How should WACC be calculated when the capital structure includes convertible bonds?
The value of a convertible bond is split into two components:
- The value of the bond carrying similar risk without the conversion option;
- The value of the conversion option, which is discounted at the company’s cost of equity.
The value of the conversion option is calculated using the standard call option pricing formula:
See also: Valuation of Employment Compensation with Options and Grants
P.S.
The chart shows how convertible bonds trade in the market at different stock price levels:
Source of the chart: What are convertible bonds?