Convertible debt proceeds: Allocation methods and evidence of market valuation

The primary objective of this study is to evaluate the value relevance of the separate debt and equity components of convertible debt issues, as computed by the with-and-without method as discussed in the FASB's Discussion Memorandum (August 1990). If the relative informational content of the separate components provided by this model better explains a firm's market value of equity than that of current accounting measures, it could be considered to provide estimates that are consistent with the market's valuation of those components. Thus, the model will be precise enough to be useful in reporting the separate debt and equity components of convertible debt issues. Operationally, this study regressed the market value of firms' equity on the firms' assets, liabilities (other than convertible debt), and the debt portion of convertible debt. Specifying the debt portion of the convertible debt requires modeling the with-and-without method discussed in the FASB's Discussion Memorandum. Having operationalized that model, this study empirically separated the convertible debt into the debt portion and the portion attributable to an option on equity. (1) If the market acts like there is a debt component to convertible debt, and (2) this study has adequately measured the debt portion of convertible debt, then the debt portion of convertible debt will behave like other liabilities in the regression.; Regression analysis results provide support that the present value calculated debt portion of convertible debt issues provides statistically significant explanatory power of the market value of firm equity. The coefficient for the present value of equity component had the expected negative relationship and was statistically significant. Therefore, the results confirm the hypothesis of this study that the present value model does provide precise enough results to be useful in reporting the separate debt and equity components of convertible debt issues.