Recent reports have suggested that should Rio Tinto's (RTP) controversial deal with Aluminum Corp. of China (ACH), or Chinalco, fall through, Rio would raise capital with a $10 billion rights issue instead. Issuing an attractive convertible bond to existing shareholders would be a better idea.

Why? A rights issue would hit current shareholders with severe dilution. Assuming a rights price subscription discount of 25%, which is conservative for a company in Rio's position, Rio would have to issue around 94 million shares to raise $10 billion, over one-t2hird of the company's current shares outstanding. Assuming a 37% dilution from the rights issue, next year's earnings would drop from the current FactSet consensus estimate of $14.38 per share to $10.45 per share.

On the other hand, if Rio could get a $10 billion convertible bond deal done, paying an interest rate of 9% and using a conversion price of around $190, up 30% from where its shares have been trading recently, the company could set a conversion ratio of 5.26. Core earnings per share would be less affected in the near term and diluted earnings per share would be reduced by only $1.13 per share.

Convertible bond holders would also be able to be invested in a more senior tranche in the capital structure, and the financing cost to the company would remain relatively the same as in the original Chinalco financing plan.

Compared to Rio's bond offering Tuesday, a $3.5 billion debt issue yielding 9.25% to 9.375%, the convertible could be offered at a lower interest rate and interest payable would still be tax deductible. Since Rio paid an average tax rate of 46% last year, the company could save $414 million offering a convert at 9% rather than conducting a rights issue.

Other options for Rio include asset sales and rescheduling with existing debt holders. The former would dilute the company's long-term market position, while the latter might be difficult in the current credit climate.

Rio would not be breaking new ground by issuing a convertible. ArcelorMittal (MT) recently issued $1.5 billion of notes paying coupons of 7.25% to 7.75%. The conversion price was set at a price some 30% above where its shares had been trading. That offering was oversubscribed by five times, and the stock is now up near the conversion price.

Given the variety of obstacles to the Chinalco deal, which range from angry shareholders to suspicious Australian lawmakers, Rio needs a Plan B. It should be a convertible, and the rights issue should be demoted to Plan C.

(All figures are in U.S. dollars and relate to Rio Tinto's U.S.-listed ADR.)

(Kevin Nichols is a columnist with Dow Jones Newswires. He can be reached at 201-938-2094 or by email at kevin.nichols@dowjones.com. Dow Jones Newswires is enhancing its news, commentary and analysis for the investment banking community, and is providing it on this service temporarily. Stay tuned for information on continued access to the best of Dow Jones news and opinion on companies, sectors and deals for bankers and research analysts.)

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