Convertible Bonds vs. Debt with Warrants: A Comparison | CFA® Level 1 Exam

Understanding Convertible Bonds and Debt with Warrants

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Question

Firm A issues convertible bonds to raise capital in the amount of a million dollars. An identical Firm B issues debt with warrants attached to raise the same amount. Which of the following statements is/are true in this situation?

I. Firm A ignores the convertibility feature completely while recording the bonds.

II. Firm B's interest expense is higher than that of Firm A.

III. Both the firms recognize the dilutive effects of the debt while calculating EPS.

Answers

Explanations

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A. B. C. D.

A

While both convertible bonds and bonds with attached warrants derive significant value from the possibility of conversion to common stock, the accounting treatments for the two are quite different. With convertible bonds, the conversion feature is completely ignored and the bond is recorded as an ordinary bond. On the other hand, the proceeds from a bond-with-warrant issue are divided into two groups: those related to the bond and those related to the warrant. The former is recorded as a liability while the latter is directly added to equity, without any income statement effects. This leads to a bigger amortization of a discount (or a smaller amortization of premium) with a warrant-debt than with a convertible bond. This effect offsets the fact that a higher liability is recognized with a convertible bond. Hence, the interest expense is higher in general when debt-with-warrant is issued.

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