When calculating WACC, what impact does out-of-the-money convertible debt have?

• A. It is ignored completely
• B. It is counted as equity
• C. It is counted as debt
• D. It enhances the company’s market value

Answer: (C)

When calculating the weighted average cost of capital (WACC), out-of-the-money convertible debt is treated as debt. This is because the terms of the convertible debt imply that it does not currently convert into equity, as the conversion price is higher than the market price of the underlying shares. Therefore, it retains its nature as a debt obligation on the balance sheet, impacting the capital structure in a way that factors into the overall cost of capital calculation.

Additionally, since the convertible option is not exercised when it is out-of-the-money, it does not contribute to the equity component in the WACC formula. The cost of this debt is included in the WACC calculation based on its interest payments and the market value of the debt. Consequently, the presence of out-of-the-money convertible debt can influence the company’s overall cost of capital by reflecting its debt obligations in the calculation, rather than benefitting from enhanced equity valuations or being ignored entirely.