Some people like to play a game that constructs a sequence of chemical elements where each element in the sequence begins with the last letter of its predecessor. For example,….
what would be the effect on the company’s debt to equity ratio, and what would be the effect on the percentage ownership of the company by other stockholders?
During economic recessions, occupancy rates of hotels generally decline, and as a result, the hotels are forced to reduce their room prices. The impact on a hotel’s cash flows may be such that it is unable to pay its debts when they come due. Some years ago, the Hospitality Research Group studied the financial statements of 3,300 hotels. It found that 16 percent of hotels were unable to generate enough cash from operations to make debt repayments in 2000. The study estimated that this figure would increase to 20.9 percent in 2001 and 36.5 percent in 2002.15 What alternative sources of cash might be available to hotels whose cash flows from operations are inadequate to cover debt repayments?
Characteristics of Convertible Debt
Amazon.com, Inc., gained renown as an online marketplace for books, records, and other products. Although the increase in its stock price was initially meteoric, only recently has the company begun to earn a profit. To support its enormous growth, Amazon.com issued $1,250,000,000 in 43⁄4 percent convertible notes due in 2009 at face value. Interest is payable on February 1 and August 1. The notes are convertible into common stock at a price of $78 per share, which at the time of issue was 27 percent above the market price of $61.50. The market value of Amazon.com’s common stock has been quite volatile, from $34 to $57 in 2004.16
What reasons can you suggest for Amazon.com’s management choosing notes that are convertible into common stock rather than simply issuing nonconvertible notes or issuing common stock directly? Are there any disadvantages to this approach? If the price of the company’s common stock goes to $100 per share, what would be the total theoretical value of the notes? If the holders of the notes were to elect to convert the notes into common stock, what would be the effect on the company’s debt to equity ratio, and what would be the effect on the percentage ownership of the company by other stockholders?