Abstract
Convertible bonds are attractive because they offer alternatives for both issuers and investors. Therefore, several companies have used this financial mechanism to raise capital. Although several studies have been published on this topic, mandatory convertible bonds (MCBs), which are subsets of convertible bonds, and their effect on economic value added (EVA) have not been explored deeply. This study analyses what happens to the EVA before, during and after the issuance when investors are involved as shareholders of a company issuing MCBs. A Colombian company is used as a case study. The results reveal that one of the main reasons behind the change in the EVA is not only the weighted average cost of capital or the invested capital but also the operating profit. The net operating profit after tax (NOPAT) depends on operating profit. Therefore, to generate a positive EVA, the NOPAT margin needs to be higher than the margin of financing costs.
Introduction
Currently, sufficient studies have been conducted on convertible bonds. Given the strong relationship of convertible bonds with stocks, convertible bonds became a hot topic in fixed-income securities research in 2003 (Yan et al., 2018). However, existing literature on mandatory convertibles bonds (MCBs) is scarce (Huerga & Rodríguez-Monroy, 2019a).
According to data obtained from Scopus and those analysed using VOSviewer software, there are only two papers published on MCBs, namely Ammann and Seiz (2006) and Huerga and Rodríguez-Monroy (2019a). This study was performed using ‘mandatory convertible bonds’ as the keyword for the abstract and title. To obtain more evidence on this type of bond, the study was extended to ‘convertibles bonds’. The study returned a total of 486 published papers. Furthermore, theoretical models on firms’ choices between mandatory convertibles and other securities were identified.
The most influential authors who have studied convertible bonds include Brennan and Schwartz (1977), Eckbo (1986) and Stein (1992). The first author studied the theory of option and warrant pricing in the context of security market equilibrium. The second author analysed the effect of corporate debt offerings on stock price and found that straight debt offerings cause non-positive price effects, and that convertible debt offerings represent considerable adverse effects. The third author indicated that corporations may use convertible bonds as an indirect way to obtain equity into their capital structures when adverse-selection problems make a conventional stock issue unattractive.
According to Batten et al. (2018), ‘a convertible bond is a path-dependent derivative that is equivalent to a bond with an embedded call option on the firm’s stock’ (pp. 1). Likewise, Kim and Han (2019) indicated that a ‘convertible bond is a type of corporate bond that is classified as a hybrid security because it can be converted into common stock under the conditions specified in indenture’ (p. 1). Therefore, investors receive converted debt-to-equity time or fixed coupon payments.
MCBs could be considered a convertible bonds’ subset and is mainly designed to facilitate debt-to-equity conversion (Gonzalez-Ruiz et al., 2019). Given its special features, this has changed the traditional knowledge and concepts of equity and debt. It is not just an instrument for entrepreneurs, and these have even been issued by several companies to raise capital, for example, Texas Instruments, General Motors, Citicorp, Sears, Kaiser Aluminum, Reynolds Metals, American Express, First Chicago, Boise Cascade, All State, AT&T, K-Mart and Motorola (Chemmanur et al., 2014). As a result, firms can raise financial resources either by issuing mandatory convertibles or by issuing more conventional securities such as straight debt, ordinary convertibles or equity (Huerga & Rodríguez-Monroy, 2019b). In this vein, firms issue this type of bonds when they perceive these securities to be a cheaper form of financing than straight bonds and equity (Dong et al., 2018). Given that they are more attractive to investors, like hedge funds, and because of the higher value of their conversion option and their lower credit risk, they play a pivotal role in the segment of the corporate bonds market (Batten et al., 2018).
According to Dutordoir et al. (2014), approximately 75 per cent of issues are purchased by arbitrage hedge funds, which are confined to pricing and profitability strategies in asset efficiency. Li et al. (2016) mention that both financial and non-financial institutions evidenced that their share price was negatively affected after issuing convertible bonds. This argument supports the need to understand the issuance of convertible debt via another financial scope, such as the economic value added (EVA); this is one of the reasons why the EVA behaviour during the issuance and conversion will be analysed. In this way, despite the growing literature on convertible bonds, there is no direct evidence indicating that MCBs generate value for shareholders. Although several challenges exist regarding MCBs and EVA from the academic and commercial arena, there is no information in the current literature about the relationship between them to the best of the authors’ knowledge. Thus, the present study is relevant, as it is one of the very few studies that analyse the relationship between MCBs and EVA from an empirical perspective.
The article is organised as follows. The second section reviews the literature. Related works on the EVA, as well as how it is estimated and what it intends to explain are presented. This section also includes a review on convertible bonds, primarily MCBs. It explains why these bonds are attractive in the financial market and why managers have incentives to promote their issuance. The third section provides the objective and states the rationale for the study. The fourth section provides information on the data and methodology used. The fifth section presents a case study. The sixth section reports the empirical findings and analysis. The seventh section presents the discussion and conclusion. The final section concludes the article by summarizing implications, limitations and scope for future research.
Review of Literature
This study performed a comprehensive, systematic and holistic literature review of all research papers published in leading journals regarding convertible bonds, MCBs, weighted average cost of capital (WACC) and EVA. As mentioned earlier, research papers derived from the Scopus database are used to ensure that the most important works are cited in this article. According to Waltman (2016), Scopus is one of the databases with the highest academic research reputation. The analysis is supported by an illustrative map provided by VOSviewer version 1.6.13. This software allows the visualization of bibliometric networks, including journals, researchers and individual publications among others. Given its usefulness for performing literature review analysis, it has been used in several studies (Castillo-Vergara et al., 2018; Ertz & Leblanc-Proulx, 2018; Sarkodie & Strezov, 2019).
Economic Value Added
In 1961, Miller and Modigliani (1961) developed the foundations of EVA and published their findings in the seminal paper ‘Dividend Policy, Growth and the Valuation of Shares’ in the Journal of Business. Thereafter, these ideas were extended at the beginning of the 1990s into the concept of EVA by Stewart & Co (Sabol & Sverer, 2017), who registered the trademark.
Financial strategies and statements have often been used to express results in profits and returns; for EVA, the approach changes. This approach claims to be superior over traditional accounting-based performance measures like return on assets (ROA) and return on equity (ROE) by explaining annual stock returns (Agrawal et al., 2019; Venugopal et al., 2018). According to Young and O’Byrne (2000), the EVA calculation indicates the difference between the return on capital and the cost of capital. Therefore, it represents the excess in returns or profits after considering the expected return for both debt holders and shareholders (Chakrabarti, 2000; O’Byrne, 2019). The EVA is generated by deducting the operating profit of the company from its taxes and is then used to pay the interest from the debt structure (cost of debt) and to give shareholders the expected return from their investment (Cachanosky & Lewin, 2016). They need to consider the assumed risk, the dividends paid and the stock price increase in the cost of equity expected for the given investment. All of these deductions (except for the tax deduction) can be summarized in the WACC (Jankalová & Kurotová, 2019). In other words, it can be seen as the excess in the WACC coming from an investment. This excess should be calculated as the operating profit after tax measured as a percentage of the invested capital, that is, return on the invested capital (Sharma & Kumar, 2010). There are multiple arguments against the EVA.
The most popular arguments claim that it is an economics criterion based on accounting dimension to measure created value for shareholder (Narang & Kaur, 2014). The fact is that the value-added approach is still relevant, and every company should work towards improving the value it generates (Kaur & Narang, 2010). In this way, the EVA involves stakeholders who are important to company performance. Thus, the EVA is a measure of economic profit and is the best available metric for measuring value (Venugopal et al., 2018; Young & O’Byrne, 2000).
The EVA does not work in every economic situation, and it does not work in financial crisis because firms hold cash balances as a response for failing credit markets (McLaren et al., 2016). On the other hand, some authors support EVA (Cachanosky & Lewin, 2016). Shareholders are always looking to maximize their investments. It is not merely about the returns but also about value management. This is why value-based management, which is related to the EVA metric, comes in handy because it meets shareholders and customers’ needs (Berzakova et al., 2015). Additionally, one of the EVA’s most essential features is to allow owners to assess the operational results by considering their own invested capital (Rajnoha et al., 2012). Xin’e et al. (2012) concluded that using value measures, like the EVA, involves the speculative capital opportunity cost and facilitates the setting of value creation as the main criterion for financial performance. Another characteristic is that the EVA determines business performance criteria and the effectiveness of its financial structure. It also represents a single reference rate for the various activities of the company (e.g., financial and investment activities) (Jakub et al., 2015). Shah et al. (2015) observed a substantial support of EVA, provided evidence of its supremacy as a financial performance measure over conventional methods and provided the actual business financial depiction.
The EVA is very precise because it comprises the cost of debt financing, which could include MCBs and equity financing. In this way, EVA has attracted great attention as an alternative way to traditional accounting earnings for use in both employee compensation and valuation (Biddle et al., 1999). Given that the EVA for private entities (for areas in companies) can be calculated, it can be used as an encouraging tool within organizations. Conventional managers know that their companies need to supervise operating costs to succeed in commercial markets. At present, businesses must also be competitive in capital markets by keeping their capital costs low (Young & O’Byrne, 2000). This is why EVA is commonly used, nowadays, as a performance index for defining the compensations of managers and groups of employees (Kleiman, 1999). To describe the financial situation of any company and to calculate the value that was generated, the EVA methodology can be adopted as a suitable solution (Jankalová & Kurotová, 2019). Therefore, EVA is recognized as an important tool for performance measurement and management all over the world, particularly as a component of corporate strategy in advanced economies (Sharma & Kumar, 2010).
Mandatory Convertibles Bonds
MCBs are equity-linked hybrid securities that automatically (mandatorily) convert into common stock on a predefined date. MCBs are hybrid securities that share the characteristics of both debt and equity. They regularly take the forms of bonds and pay coupons. However, upon redemption or at maturity, they are mandatorily converted into a fixed or limited number of common shares, and no cash or other security is delivered. Given that these bonds are similar to equity, rating agencies give them a high equity component, and they are commonly treated as equity by accounting standards (Huerga & Rodríguez-Monroy, 2019a).
Therefore, companies have an incentive to turn to mandatory convertibles. For these securities, given that the conversion to equity is mandatory, companies do not have to be concerned about incurring financial distress costs if such securities are issued instead of straight debt or ordinary callable convertibles. Furthermore, mandatory convertibles allow companies to reduce the firm’s securities undervaluation scope (Chemmanur et al., 2014).
According to Wang (2017), convertibles and their debt characteristics are appealing to investors at early stages; their convertibility in later stages enables companies to convert debt into equity and to return to the capital market for further funding. The most frequent reason to invest in convertible securities is that they allow advantageous participation with downside protection. This is partly true for mandatory securities because the holder retains the stock’s downside risk. However, it can be argued that the leading investment objective is to obtain equity exposure with a lower portfolio volatility than that of common stock (Nijs, 2014).
Mandatory convertibles are the most similar to equity among all convertible securities, and they provide little downside protection because mandatory convertibles usually do not have fixed terminal value unlike normal convertibles (Ammann & Seiz, 2006).
In this way, a convertible bond is a bond with an option for the holder to exchange it into ‘new’ common stock shares for the issuing company under specified terms and conditions. These could include (a) periods during which the bond may be converted into shares (conversion period), (b) number of shares received per converted amount (conversion ratio) and (c) effective price paid for the common stock (i.e., ratio of the face value of the convertible to the conversion ratio [conversion price]) (Nijs, 2014). MCBs have three unique characteristics: (a) mandatory conversion to equity at a specified date (usually in 3–5 years), (b) a high dividend rate (much higher than the dividend rate on the underlying common stock) and (c) capped capital appreciation (usually on the upside) (Wang, 2017).
The profit at the emission of convertible bonds is lower than that in the same issuer’s more senior debt (Nijs, 2014). The issuer of a convertible bond taps into two advantages (Nijs, 2014). First, the investor pays for the right to partake in future favourable price fluctuations in the underlying common stock that is compliant with a lower yield and less restrictive covenants. This represents a lower interest cost and less restrictive covenants than non-convertible bonds. Second, the issuer receives the advantage of more senior security via principal and relative income stability. Consequently, it is an attractive tool for those who deal with discrete equity market risk allocation constraints. The price behaviour of a convertible security is determined by its debt and equity components; it presents very similar features to the option valuation models (Nijs, 2014). Therefore, its value is measured as the value of the bond plus the value of the option to exchange it (Finnerty, 2015).
According to Nijs (2014), the traditional motives for the issuance of convertibles include the deferred trading of stock at an attractive price and a competitive form of raising capital. Convertibles are relatively insensitive to the issuing firm’s risk; therefore, convertibles may lead to lower agency costs between share and bondholders (Frierman & Viswanath, 1994; Nijs, 2014). As stated in Lyandres and Zhdanov (2014), issuing straight debt leads to underinvestment because of the delays associated with it compared with equity-based investment.
According to Chemmanur et al. (2014), the main features of MCBs are as follows: (a) conversion to equity is mandatory at the maturity of the convertible, (b) mandatory convertibles have either a capped or limited appreciation potential compared with the underlying common stock and (c) the dividend yield on a mandatory convertible is typically higher than that on the underlying common stock. Therefore, bondholders find it ideal for converting their bonds into equity only after the stock price passes a programmed threshold (the conversion price) (Rastad, 2016).
In the past decade, the use of mandatory convertibles has increased as a tool for raising capital by firms. Among convertibles, MCBs are the most equity-like convertibles, and they represent a major innovation in securities (Wang, 2017). This significant financial improvement emerged as an attempt by companies to simultaneously decrease the total costs from asymmetric information and financial distress. Mandatory convertibles allow companies to reduce the extent of the firm’s securities’ undervaluation. Given that some undervaluation of intrinsically higher-valued firms is inevitable if mandatory convertibles are issued, such undervaluation is lower than if the firm issued the other securities; this does not increase the possibility of the company going into financial distress (such as in equity) (Chemmanur et al., 2014).
Convertible bonds have been very attractive since the 2008–2009 financial crisis. This type of security allows corporations to increase the value of tax shields (due to the debt component), while keeping the default risk at a low level.
In this way, ‘companies need to raise capital when new investment opportunities arrive, and convertibles are optimal because they allow new access to capital markets with no increase in default probability if the conversion is triggered’ (Huerga and Rodríguez-Monroy, 2019a). This approach is related to performance-sensitive debt (Ming et al., 2018).
One more motivation factor that leads to the emission of some mandatory convertibles may be the customers’ effects (i.e., the desire of the issuing firms to take advantage of institutional investors’ desire for higher dividend-paying securities). Furthermore, many mandatory convertible securities offer tax benefits, for example, deductibility of the paid dividend similar to the coupon paid on corporate debt (Chemmanur et al., 2014).
It is expected that the offer of convertible bonds will lead company managers to make better investment decisions. If the convertible bond offer proceeds are also used to finance real investments, a decrease in the issuer risk and expected return should be observed (Zeidler et al., 2012). The future debt level adjusted by the bondholders’ conversion behaviour promotes an opportunistic management. This cannot be attained by any financial structure composed of only common debt and equity (Dorion et al., 2014).
Corporate managers issue more convertible debt during bull markets and when the interest rates are relatively high. Concerning the issuance timing, there is no relation at the aggregate level between the issuance of convertible debt and the episodes of high stock market volatility (Isagawa, 2000).
To obtain a better understanding of what topics have been researched on convertible bonds, VOSviewer software was used not only for plotting the networks of topics but also for analysing the importance of these networks in this research area. Thus, Scopus database was used to collect the data needed to make the network (Figure 1). It was selected because this database contains the most relevant and influential journals. According to Waltman (2016), this database is one of the databases with the highest academic research reputation. To obtain concise results from this database, ‘convertible bond’ was used as the keyword.
Objective and Rationale of the Study
Although several studies analysed value creation from the EVA’s context, no substantial research has been carried out that specifically addressed the relationships between EVA and MCBS from a corporate value creation perspective. Thus, to help bridge the identified knowledge gap, the purpose of this article is to analyse what happens to the EVA before, during and after the issuance when investors are involved as shareholders of a company issuing MCBs.
To the best of the authors’ knowledge, given that studies have not explored deeply the relationship between MCBs and EVA, and there is no direct evidence indicating that MCBs generate value for shareholders, the current study represents an important development in the literature by analysing this type of relationships. Hence, on the basis of the analysis of the network presented earlier, it was possible to confirm that research on MCBs and value generation relation is scarce, and thus, it is one of the very few studies that analyse this relationship from an empirical perspective.
This study will help improve the knowledge of both practitioners and researchers to expand their knowledge frontier on this financial mechanism and EVA. To conduct this analysis, Grupo Argos, which is a Colombian company that issued convertible bonds, is used as a case study. Thus, this topic was studied to narrow the knowledge gap. Therefore, the present study is relevant as it is one of the very few studies that analyse the relationship between MCBs and EVA from an empirical perspective. The study is carried out in hoping that the findings can serve to highlight the fact that researchers and practising professionals can improve their understanding on the relation between EVA and MCBs. Therefore, studies based on MCBs and WACC may be an attractive gateway to the financial decision-makers to analyse financing strategies of investment plans and their impact on the EVA.
Data and Methodology
To analyse the financial behaviour, which was measured by EVA, the data collection process was completed using Bloomberg terminal. Financial metrics such as net operating profit after tax (NOPAT), invested capital, financing cost, revenues and WACC have been used in this study. These are all time series annual data for the period from 2010 to 2017. Thus, EVA has been calculated each year during the period examined. Apart from providing empirical information on financial metrics of Grupo Argos over time, these data have been used for the exercises of analysis of the problem of this study.
e literature review reveals the existence of a knowledge gap regarding the identification of whether the issuance of MCBs could have a negative effect on EVA performance. To explore the effect of MCBs on EVA, Grupo Argos, which issued MCBs in the Colombian stock market in 2012, was used as a case study for validating the hypothesis. This is one of the largest investment companies in Colombia. To analyse the financial behaviour, which was measured by EVA, the data collection process was completed using Bloomberg terminal as mentioned earlier. Therefore, the research problem involves investigating the relationship between MCBs and EVA. Thus, the following hypothesis was developed:
The following equation was used to measure the EVA:
Case Study
Grupo Argos is a Colombian holding company with investments in different sectors. Its legal nature corresponds to a corporation registered in the Colombian Securities Exchange as well as its subsidiaries Argos (cement), Celsia (energy) and Odinsa (road and airport concessions) (Grupo Argos, 2013). Grupo Argos, which is the parent company of Grupo Empresarial, has strategic investments in listed companies and private companies; it also has a robust portfolio of investments.
In the Colombian Securities Exchange, Grupo Argos is an issuer of ordinary shares, preferred shares and fixed income securities, represented by strategic investors, private investment funds, pension funds, brokerage firms and investors (in general, individuals interested in participating in the country’s securities market) (Grupo Argos, 2013).
In 2012, Grupo Argos owned 61 per cent of Argos, 50 per cent of Celsia and 100 per cent of Odinsa. The holding’s revenue was US$3.1 billion in 2011. Argos has been the leader in the cement market in Colombia since 1934. Its revenues in 2011 were US$2 billion, and it has 7,800 employees. Argos is the fifth largest cement producer in Latin America and the fourth largest in the USA. On the other hand, Celsia is the fourth largest power generator in Colombia. The revenues in 2011 were US$1 billion, and it has 1,000 employees. In 2012, Argos split its real estate investments, port assets and carboniferous to create Odinsa.
Grupo Argos issued COP 750,000 million (approximately US$405.6 million) as mandatory convertibles into shares with preferred dividends. The issuance consisted of five series. The analysis conducted in this article is based on series A, which represented two-thirds of the total debt allocation (i.e., COP 500,000 million). Series A was issued on 26 November 2012.
The nominal value of the bonds was COP 1 million; therefore, 500,000 bonds were issued. Given that the nominal value of the bonds was very accessible to Colombian market players, it was bought by hedge funds and individuals. This made the offer more attractive and influenced the issuance demand. The exchange rate for the bonds was 47 shares per bond. The share price at that time was COP 19,200. After dividing the nominal price of the bond by the number of shares in the conversion rate, the current price paid for each share would be COP 21,276. This indicates that Grupo Argos’ current stock price was undervalued compared with the valuation of the convertible issuance. The equity price of the mandatory convertible was valued at 10.8 per cent above its current value.
Fitch Ratings Colombia S.A. rated the bond AA+ because of the solid credit quality of Grupo Argos’ investment portfolios, the diverse liquidity sources available and the expected reduction on financial debt levels (Grupo Argos, 2013). The coupon rate was defined as 5.0 per cent nominal quarterly compound. This indicates that each bondholder would receive quarterly payments of COP 12,500 as interest. Grupo Argos expected to obtain the following results with the issuance of the mandatory convertibles: (a) increase equity capacity, (b) strengthen the capital structure (optimizing the cost of capital, strengthening the credit profile of the company and differentiating the sources of capital), (c) improve the liquidity conditions of the action and (d) mitigate the share’s effect price in the market via a mechanism wherein gradual conversion is distributed over 2–5 years.
Empirical Findings and Analysis
In this section, we present the results of our empirical analysis. The financial information of Grupo Argos comes from Bloomberg. This information was taken from 2010 to 2017. As mentioned before, the first step is decomposing the EVA. The EVA decomposition was achieved by analysing the two main parts, namely the operational and financial parts, which include the NOPAT, the invested capital and WACC (Jakub et al., 2015).
The MCBs issued by Grupo Argos was used to finance the debt structure; thus, changes in WACC were considered in the conversion period in this analysis. Equation (1) was use for the analysis.
The NOPAT reflects the operational behaviour and performance of the company. This can be analysed from several points of view, such as margins, tax efficiency and market situation. On the other hand, invested capital × WACC reflects the financing cost of the company. This is because the company is expected to have a return on capital higher than the WACC. The WACC will reflect the cost needed to satisfy the shareholders’ and debt holders’ expected returns (Daves & Ehrhardt, 2007). The excess in the operational return value and the financing cost value provides added value to the company (i.e., the EVA).
Figure 2 presents the behaviour of Grupo Argos’ EVA before the emission, during the debt period and after the debt–equity conversion. The EVA was very volatile during these periods. Before the emission (2010 and 2011), the company improved its EVA, which was already negative for both periods. In 2012, the company reflected another improvement; at this time, it would have been expected to observe a significant change in the EVA because of the change in financing costs.
There were significant changes in 2014, including a negative EVA, that was even worse than that in 2010. In this year, bond conversion occurred, thus bringing theoretically dramatic changes in financing structures. The year 2015 showed the best EVA. During this period, the most significant change in the structure of EVA occurred, and this change continued throughout 2016 and 2017. Therefore, there were important changes in the EVA. These changes need to be analysed to understand if they occurred owing to bond emission. Therefore, the EVA needs to be decomposed, such as in Equation (1). The decomposition will explain the behaviour of EVA in two main parts: operating profits and financing costs.
In 2012, there was a significant increase in the financing costs (Figure 3). This increase was compensated by a more significant increase in the operating profit structure. There were significant changes and volatility in both NOPAT and EVA. To further understand the changes that reduced the economic effect on those variables, it is necessary to consider them as a percentage of revenues. Figure 3 presents both the variables and EVA itself as a percentage of revenues.
On the basis of an analysis of the percentage of revenue, the volatility can be reduced by the adjustment from the sales variations. This also occurs if we understand the financing costs as a percentage of revenues (Figure 4). By doing so to both of the EVA components, a trend can be spotted and both margins will collide (margin is the result of dividing the variable by revenues). To generate a positive EVA, the NOPAT margin needs to be higher than the financing costs’ margin. From 2010 to 2014, the gap between these two lines was negative but became smaller over time. However, in 2015, the gap was positive; this explains the positive EVA. Figure 4 also shows a tendency to generate EVA with a step back during 2014. This year must be analysed to understand whether the problem was caused by the conversion of the bonds during this period.
The financing costs are calculated by estimating how much the company should operationally generate to satisfy the expectations of its stakeholders. The main stakeholders involved are debt holders and shareholders. Each of them expects different returns from their investments, owing to the risks assumed. The total investment made from them is considered the invested capital. The capital used by the company to invest in operational assets is based on the term duration of the investment or the financing type.
To estimate how much the stakeholders expect from their investment, the weight of each of their expected returns needs to be calculated. The weight measurement must be performed in market terms. Market terms refer to the debt and equity value in the market. It is very different from the accounting terms because Grupo Argos is listed in the Colombian stock exchange. Its equity value is equal to the number of shares multiplied by its individual price, that is, the market cap. Regarding debt, its current market value should be considered. The debt market value considers the changes in risk-free rates and risk changes analysed by the rating firms.
The operating profits can be understood by decomposing them into two main branches: net operational benefit minus the operational tax expense. During the observed periods, NOPAT margin shows high volatility, and it is the main reason for the different results obtained for the yearly EVA. The lowest NOPAT margin period is 2014, which is also the lowest EVA period. This relation indicates that the company’s operational behaviour causes the fluctuation in the EVA results. As seen in Figure 5, 2014 is the period with the smallest gap between the operational benefit and the operational tax expense. This explains why it has the lowest NOPAT margin. This is caused by the huge operational taxes and not a deficit in operating profit.
By analysing the behaviour of the WACC, it was found that the mandatory conversion had an effect on the capital structure, particularly in 2013 and 2014. From a theoretical perspective, this issue is supported by Rastad (2016), which indicated that the conversion of a convertible bond into equity creates a decrease in leverage. Based on the case study, this is due to the fact that in 2014, the MCB was converted to equity shares, and thus, the ratio of debt to equity changed. As a consequence, considering that the cost of equity is higher than the cost of debt, the change in the capital structure allowed the WACC to increase considerably from 2013 to 2014 as presented in Figure 6. In this way, as expected, there was a significant increase in the WACC because of the more substantial equity participation; this increased the weight and raised the WACC. This year was the highest WACC in the period examined.
The other component is the invested capital, which shows an increasing tendency after conversion year, driven by organic and inorganic growths. These investments were financed in a higher proportion with debt, and thus, the reduction in WACC is significantly higher as shown in Figure 6. This explains the attenuation in the financing costs as a percentage of sales. In this way, empirical findings show changes on the capital structure and the WACC in the conversion year as supported in theory.
Discussion and Conclusion
Grupo Argos, which is a Colombian investment company, issued MCBs in November 2012. The conversion period was 3 years from 2012 to 2015. The purpose of the issuance was to improve its capital structure. Throughout this period, there were substantial changes in the EVA changes from 3 per cent to 155 per cent. It was first believed that the changes in the EVA were due to this financing strategy, which affected the WACC. The results of this study revealed that one of the main reasons behind the change in the EVA was the operating profit (not just the WACC or the invested capital). The NOPAT depends on operating profit. Thus, to generate a positive EVA value, the NOPAT margin needs to be higher than the margin of the financing costs. Furthermore, the results indicate that although there was not a noticeable increase in the EVA from 2010 to 2014, the gap between the NOPAT and the margin of the financing costs became smaller over time (Figure 4); in 2010 and 2017, the gaps were 11.12 per cent and 0.01 per cent, respectively.
As expected, the issuance of MCBs affected WACC significantly. From this perspective, by observing it as an independent variable, there was a reduction in the WACC levels, owing to the issuance composition wherein there is a mix of debt and equity. In 2010, it was 6.7 per cent, and it decreased to 4.0 per cent in 2017. Therefore, Grupo Argos fulfilled one of the expected objectives with the issuance of the mandatory convertibles, that is, the optimization of the cost of capital. If the operating profit of the company had remained stable during that time, the EVA of the company would have significantly improved.
The conducted analysis weakens the previously published research results in Abhyankar and Dunning (1999), which indicated that there is evidence of negative wealth effects for convertible bond and preferred stock issuers whose stated issuance objective is to refinance the previous debt, finance specific acquisitions or adopt mixed financing. However, companies that issue convertible bonds to finance capital expenditure schemes display a small but substantial positive wealth result.
Implication, Limitations and Future Research
Given that MCBs’ emissions are not very common, this study contributes to previous research in the emission of MCBs and their effects on the WACC and EVA. Likewise, this has provided valuable suggestions to practitioners, in order to help them to maximize EVA through management of capital structure. Thus, practising professionals may use this study’s findings to broaden the central aspects of MCBs, WACC and EVA. In this way, this also provides new insights into how MCBs impact on the capital structure and, thus, EVA changes.
Furthermore, this study generates academic and practical content on MCBs, in which research is scarce, particularly information of an empirical nature.
Despite the contributions of the present study, limitations should be acknowledged. The main limitation was the lack of these types of securities’ emissions, particularly in the Colombian market. Thus, obtaining relevant information that would permit the correlation of variables or performing more robust statistical analyses to contrast results was not possible. This fact did not allow the analysis or comparison of companies in which the effect of the emission of MCBs in the EVA could be observed. In this way, it is possible that aspects not identified in this study may be important for establishing new ways to identify how value could be measured by financing with MCBs. This issue should be addressed in future research. Another limitation is that in Colombia, there is no other company with the same strategic focus or the same dimensions as Grupo Argos for the comparison of market behaviour.
This study could be replicated in a more developed financial market wherein there are higher leverage and more comparable companies. The literature review and results of the studies clearly indicate the need for future research to validate further hypothesis on this topic. On the basis of the analyses conducted, topics for future research can be obtained. It is worth noting that it is based on the problem of the agency and the generation of value, considering convertible securities. Likewise, the use of sustainable green bonds and social bonds, which are related to the Sustainable Development Goals, could be considered as a new way of creating value. Specifically, these are recent financial mechanisms that have not yet explored the conversion of debt to equity. Both agency problem and these types of bonds can be the basis of future research.
Based on the findings, significant potential exists in both academic and practical arenas for the continued development of this body of knowledge. Therefore, further research efforts are needed to have a better understanding of how the financial process can boost corporate value.
Footnotes
Acknowledgement
The authors are grateful to the anonymous referees of the journal for their extremely useful suggestions to improve the quality of the article. Usual disclaimers apply.
Declaration of Conflicting Interests
Funding
The authors received no financial support for the research, authorship and/or publication of this article.
