Convertible Securities, Employee Stock Options and the Cost of Equity

Abstract

We provide a method for calculating the cost of equity and the cost of capital in the presence of convertible securities and employee stock options. We demonstrate how this approach can be applied if a company already has issued convertible claims or if it is considering doing so for the first time. We provide several numerical examples illustrating the significance of errors in estimating the cost of capital that can result when (1) employee stock options are ignored or (2) the observable stock price is used as a proxy for the unobservable underlying asset.

Keywords: convertible bonds, executive stock options, cost of equity, cost of capital, dilution

JEL Classification: G31, G13