On August 20, 2004, Countrywide Financial Corporation (CFC) offered new convertible security due in 2031 (the “new securities”) in exchange for an equal amount of its liquid yield option notes (Lyons, the “old securities”). For each $1,000 of the principal amount at maturity of the old securities, the company was offering to exchange $1,000 of principal at maturity of the new securities and a cash payment of $2.50. Both new and old securities are puttable and callable. For each $1,000 of the principal amount at maturity of the new securities, it could convert to a number of shares of common stock, which equals to the conversion rate (46.2820) multiplied by the average stock price in the last 20-day stock price, minus the principal, all divided by the average stock price in the last 20-day stock price. That is to say, if you sell the share right after you convert, then the equivalent conversion proceeds are 1000+P*(46.2820*A-1000)/A, where P is the current share price and A is the last 20-day average stock price. The exchange offer expired at midnight on September 17. Most investors chose to convert.
On October 20, suppose you were one analyst on the trading floor in one hedge fund covering the CFC securities at that time. On that day the company announced earnings per share (EPS) of $0.94 for the third quarter, which fell short of the analyst consensus estimate of $1.01. Before the announcement, the average price of the CFC is $37. On the announcement day, the stock price had dropped 11.5 percent to $33.17. You noticed that the trading volume of convertible bonds shot up and was abnormally high.
What could be the reasons behind the exchange offer?
- Why should the market care about the method of EPS computation?
- How are the conversion proceeds determined in the case of the new convertible security? Is this a common practice?
- Would you accept the exchange offer?
- Will the call and put features affect the pricing of the new convertible security?
- What will be the conversion proceeds in $ terms on October 20th, 2004?
- What is the reason behind the sudden increase in convertible bond trading on October 20th, 2004?
- What is the cost to the investors and the company?
