This post starts with class materials, but ends with some questions for researchers.  As I was writing my EPS case for Intermediate II this spring, I ran into a kind of strange problem.  I picked 4 or 5 companies with convertible debt and fairly sizable dilution effects.  I then went to their EPS footnote to see if I could develop some good case questions related to the numerator (after-tax interest on the convertibles) and denominator (additional shares issued if converted) adjustments.  To my surprise, I only found denominator effects.
What happened?  The convertibles had a “cash conversion feature.”  Suppose the par value on the bonds is $1 million.  On the day the bondholders convert to common, assume the stock that would be issued has a market value of $1.4 million.  In that case, the company gives the bondholders $1 million in cash and shares worth $0.4 million.  The if-converted method does not work so well for these bonds, in part because many fewer shares will be issued.  Instead, the company treats the share part of the conversion like a stock option, which means the treasury stock method is used for convertible bonds.
Needless to say, this gets a LOT more complicated than I wanted to cover with the undergrads.  But I have to admit to being very curious about the motives for this sort of structuring.  A couple of the bonds I examined started as contingently convertibles – COCOs.  Carol Marquardt and Christine Wiedman have a series of papers on the EPS management incentives underlying COCOs.  A paper in the 2007 Review of Accounting Studies covers how new guidance from the FASB basically shut down COCOs.
Does anyone know of similar research on cash conversion features?  Anyone know the real motivation behind these structures?  The company says something about wanting to limit dilution, but that would be easy to do – issue straight debt instead of convertible debt.  So something else seems to be going on.
Anyway, this seems to be an issue that can link our teaching and research endeavors.