Corning, Inc.: 2015 Convertible Zeros

AFM471 CASE 13 CORNING, INC.: 2015 CONVERTIBLE ZEROS

Advance Study Questions:

1. Why do you suppose Corning is issuing convertible bonds and concurrently offering common stock?

2. Please interpret case Exhibit 5. What are these traditional descriptive ratios? What do they show?

3. Please review the Appendix to the case below, which gives one analyst’s valuation of the bonds. Prepare to describe in class the analyst’s approach and evaluate the underlying assumptions. In particular,

 How is the straight bond valued?  How is the conversion option valued? - Should Julianna adjust the stock price for dividends?  What does Corning’s redemption option allow the company to do? When would you expect them to do so?  How are the redemption and put options valued?  Why is volatility so important? At the volatility implied in the offering price, are these bonds an attractive investment?

4. Should Coopers invest in the zeros? Please summarize your position.

Appendix CORNING, INC.: ZERO COUPON CONVERTIBLE DEBENTURES DUE NOVEMBER 8, 2015

To: Investment File From: Julianna Coopers, investment analyst Date: November 8, 2000

This memo summarizes my valuation analysis of the Corning Zeroes of November 2015. In essence, I viewed the convertible bond as having several components, which could be valued separately, then summed. The components are:

 Straight bond. This component could be valued by discounting the payment of $1,000 in 2015 at the appropriate yield on stripped bonds of similar maturity and risk.  Conversion option. This is a call option held by the investors.  Redemption option. This is a call option on the bond held by Corning. Redemption options are typically used to force conversion of a bond.  Put option. At two dates, investors have the right to put the bond back to Corning, and receive cash in return.  Change in control provision. This is a put option held by the investor. It states that any acquirer of Corning must purchase the bond from the investor at par value in the event of a change in control. Given Corning’s large size, large equity base, and strong operating position, I will assume that this right has a minimal (zero) value.

1. Straight Bond Value

In valuing the straight bond, the main decision involves choosing an appropriate risk rating. The pro-forma interest- and debt-coverage ratios show Corning as being more of an A company on some measures and being more of a BBB on others. It is unlikely, however, that Corning will be downgraded to a BBB. Corning’s pro-forma interest-coverage ratios are not any worse off than they are at present because Corning’s convertible bonds are zero coupons and require no interest payment. In addition, Corning’s debt ratios are healthier than those of A companies. One could use the median yield to maturity of all the bonds [presented in case Exhibit 8], or the average YTMs of the A bonds.1 My analysis uses the average YTM of 7.77% on the A bonds.

1 The “comparable” straight bonds are really not the best source of comparison as they are current-coupon rather than zero-coupon bonds. Zero-coupon bonds, which have higher yields to maturity because of their longer duration, are theoretically the proper benchmark for the Corning converts. However, the scarcity of comparably rated zero- coupon bonds in November 2000 prevented such a comparison in this case.

2. Conversion Option

I valued the conversion option as a call, using the Black-Scholes option-pricing model. Strictly speaking, this application violates the European option assumption of the Black-Scholes model. The Corning call option is an American option. Corning also is likely to continue paying dividends every quarter until option maturity. However, Corning pays only a small dividend, making it unlikely that the call option will be exercised before maturity. Investors are better off preserving the “time value” of the call option rather than exercising early to obtain the dividend. Because it can be expected that these options will be held until maturity (unless conversion is forced or the dividend is increased substantially), the Black-Scholes model can provide a reasonable estimate of the option value.

Volatility is the most important driver of option values, and requires an important judgment call in this case. Note the wide disparity between Corning’s volatility in the past month as against the past three months, six months, or one year. Similarly, the historical volatilities differ substantially from the implied ones. I do not favor using historical volatilities and prefer to value options using expected volatility. Will Corning perform more like that in the past month or will it be less volatile? On the one hand, Corning is a leading U.S. corporation and may be regarded as “typical” of the S&P 500, which has a volatility of 0.25. On the other hand, Corning might continue to be as volatile as it has been during the past month, with a volatility of 1.25. The analysis in this memo estimates call-option values using volatilities of 0.25, 0.75, and 1.25.

3. Redemption and Put Options

The values of Corning’s redemption option, as well as the put options allowing investors to sell their bonds to Corning in 2005 and 2010, were calculated using a binomial model. The estimates are shown in Exhibit A1. No value has been assigned to the change in control provision.

4. Value of the Convertible Bond

The value of the Corning zeros equals the sum of its parts. This is calculated in Exhibit A1 and ranges between $640.8 at volatility of 0.25, to $775.3 at volatility of 1.25. Note that the volatility implicit in the offering price of $741.923 is 0.9177. Exhibit A1 CORNING, INC.: ZERO COUPON CONVERTIBLE DEBENTURES DUE NOVEMBER 8, 2015 Convertible Bond Analysis

Straight Bond Redemption Option Maturity 11/8/2015 Coupon 0% Volatility 0.25 0.75 1.25 Yield 7.77% Value per share $ 12.64 $ 34.91 $ 41.24 Value 318.72 Dilution adjustment 0.98 0.98 0.98 Value per share, Conversion Option dilution adjusted 12.39 34.21 40.41 Term 15 years Shares per bond 8.33 8.33 8.33 Risk free rate 5.70% Value per bond $ 103.18 $ 284.98 $ 336.66 Current price $ 71.25 Exercise price $ 89.06 Put option Volatility 0.25 0.75 1.25 Volatility 0.25 0.75 1.25 Value per share $ 40.27 $ 63.77 $ 70.37 Value per share $ 11.87 $ 20.36 $ 26.85 Dilution adjustment 0.98 0.98 0.98 Dilution adjustment 0.98 0.98 0.98 Value per share, Value per share, dilution adjusted $ 39.47 $ 62.49 $ 68.96 dilution adjusted $ 11.63 $ 19.96 $ 26.31 Shares per bond 8.33 8.33 8.33 Shares per bond 8.33 8.33 8.33 Value per bond $ 328.78 $ 520.57 $ 574.46 Value per bond $ 96.90 $ 166.25 $ 219.21

Convertible Bond Value Volatility 0.25 0.75 1.25

Straight bond $ 318.26 $ 318.26 $ 318.26 Conversion option 328.78 520.57 574.46 Redemption option (103.18) (284.98) (336.66) Put option 96.90 166.25 219.21 Total $ 640.76 $ 720.11 $ 775.27

Implied volatility at offering price of $741.923 0.9177