Based on Exhibit 3, if DeLille Enterprises pays the dividend expected by Gillette, the conversion price of the DE bond will:
- be adjusted downward.
- not be adjusted.
- be adjusted upward.
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There is a point in Convertible Bonds known as a Threshold Dividend. It means a company cannot pay more than the threshold dividend to its shareholders. This is to safeguard the interest of convertible bond holders who have bought the bond instead of shares. If a company pays more than the threshold dividend, then the conversion price will be adjusted downwards and the conversion ratio will be adjusted upwards such that the convertible bond holders will receive more shares upon conversion.
For ex. the coupon amount on a bond is 80 and the conversion ratio is 25, then the threshold dividend is 80 / 25 = 3.2 per share.
Sir has explained this concept in the review class of this chapter. You can watch it for further clarification.
Hi. Whenever a dividend is announced by a company, the share price falls and it hurts the convertible bondholders. So, there has to be a certain limit on the amount of dividend that a company can pay. In this question, the maximum amount of dividend that can be paid is $0.5 per share. This is the threshold level i.e the company cannot pay dividend beyond this level. But as you can see that the company has announced a stock dividend of $0.7 per share which is not allowed. In this case the company has to lower the conversion price so that the convertible bondholders do not suffer. Hence, the conversion price needs to be adjusted downwards so that the bondholders can get more no of shares.