Convertible Bond Question from Hell. Series 7 Exam Prep

Holding periods of convertible securities are based on the original investment and not on when they get converted. The converted stock would have the same holding period as the original convertible bonds which is more than three years so the capital gain would be long term.

The original conversion price of the bond was $25 because the conversion ratio was 40 shares: ($1,000 par ÷ 40 shares = $25). However, the original cost basis per share was based on the price paid for the bond, $970. Dividing by the 40 shares makes the original cost basis $24.25 per share. The 20% stock dividend increased the number of shares from 40 to 48 shares, but then the cost basis must be adjusted as well: $970 ÷ 48 shares = $20.21 adjusted cost basis. The conversion price would be based upon par $1000 ÷ 48 shares = $20.83 conversion price. When the investor converted the bonds into stock, the market value of the bond was $1,040. To get the parity value of the common shares, divide the market value of the bond by the new conversion ratio: $1040 ÷ 48 shares = parity price per share of $21.67. Thus, the gain per share is $1.46 ($21.67 − $20.21). Multiply by the 48 shares per bond and then the 20 bonds so 960 × $1.46 is approximately $1,400.

[toothdaddy]

Dean!!! just passed my 7 and your videos were such a huge help! thank you!

[Christian]

Thank you Dean, had this in my Kaplan practice test

[Virtues]

It is one of those hard questions and you did a good job explicating the answer ! But I feel like that I need clarification on the whole process of solving the question. Could you please explain why you multiplied 40 shares by 20 % before the bond was converted?? By the time of the dividend, the bond has not yet been converted to stocks. So how can you multiply 40 shares by 20% while the bond was not converted. In other words, can the bond be eligible to the dividend before conversion? Many thanks