Question

Suppose that we are in a perfect capital market without any frictions (so no taxes, no bankruptcy costs, etc.). Consider two firms, one of which has issued standard debt and one of which has issued convertible debt. The firms are otherwise identical, and the face values of the two debt issues are the same. Compared to the standard debt, the convertible debt will generally have a lower yield and a higher expected return than standard debt.

a. True
b. False

Answer 1

In a perfect capital market without frictions, convertible debt generally has a lower yield and a higher expected return compared to standard debt.

In a perfect capital market without frictions, convertible debt generally has a lower yield and a higher expected return compared to standard debt. This is because convertible debt gives the bondholder the option to convert the debt into shares of the company's common stock. The potential upside of converting the debt into equity can attract investors, leading to a lower yield. Additionally, the potential for growth in the company's stock price can result in a higher expected return.