How should convertible debt be treated when calculating the Levered Beta if it is in-the-money?

• A. Count it as debt
• B. Ignore it completely
• C. Assume it contributes to dilution
• D. Count it as equity

Answer: (C)

When convertible debt is in-the-money, it means that the conversion price is lower than the current market price of the underlying equity, making it advantageous for holders of the convertible debt to convert their bonds into equity. In this scenario, it is crucial to recognize that the conversion would lead to an increase in the number of shares outstanding, resulting in dilution for existing shareholders.

Therefore, when calculating the Levered Beta, considering the potential dilution caused by the in-the-money convertible debt is vital. By acknowledging that the convertible debt will likely convert into equity, the total equity value changes, which directly impacts the beta calculation. This approach reflects a more accurate risk assessment for the company's equity by factoring in the dilutive effects instead of treating it merely as debt or ignoring it altogether.