Final answer:
Convertible bonds factor into the WACC calculation as they hold characteristics of both debt and equity. They can potentially lower the cost of debt due to the conversion feature and need to be adjusted accordingly. The yield on convertible bonds, which includes interest payments and capital gains, influences the WACC if there's a high likelihood of conversion to equity.
Step-by-step explanation:
How Convertible Bonds Factor into the WACC Calculation
When calculating the Weighted Average Cost of Capital (WACC), convertible bonds come into play as a form of debt with the potential to convert into equity. The cost of debt in the WACC calculation is generally the after-tax yield that the firm must pay on new borrowing. To factor in convertible bonds, you must adjust the cost of debt to reflect the possibility of conversion.
The yield or total return on a bond includes interest payments and any capital gains. Convertible bonds can affect the WACC because their cost of debt could be lower thanks to their conversion feature. When incorporating convertible bonds into the WACC, you will calculate their cost of debt based on their market rate, which may be impacted by the probability of conversion to equity. If the convertible bonds convert into stock, their cost after conversion would transition to the cost of equity, affecting the overall WACC.
For instance, suppose an investor receives a $1,000 face value bond, plus an $80 interest payment in the last year. If they bought the bond at $964 and the yield amounts to 12%, this considers both the interest payments and the potential capital gains. So when calculating WACC, if the convertible bonds are likely to be converted, the firm might decide to assign a weighted cost to these bonds that reflects the potential impact on equity rather than being limited to the bond's yield as debt.