Managerial Finance
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could be convertible into 32 shares of stock). Coupon payments will be made annually. The
bonds will be noncallable for 5 years, after which they will be callable at a price of 91,090;
this call price would decline by $6 per year in Year 6 and each year thereafter. For
simplicity, assume that the bonds may be called or converted only at the end of a year,
immediately after the coupon and dividend payments. Management will call the bonds
when their conversion value exceeds 25o/o of thetr par value (not their call price).
a. For each year, caiculate (1) the anticipated stock price, (2) the anticipated conversion
value, (3) the anticipated straight-bond price, and (4) the cash flow to the investor
asstrming conversion occurs. At what year do you expect the bonds will be forced into
conversion with a call? What is the bond's value in conversion when it is converted at
this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because
the conversion occurs immediately after the coupon is paid.)
b. What is the expected rate of return (i.e., the before-tax component cost) on the
proposed convertible issue?
c. Assume that the convertible bondholders require a 9o/o rale of return. If the coupon
rate remains unchanged, then what conversion ratio will give a bond price of $1,000?
Paul Duncan, financiai manager of EduSoft Inc., is facing a dilemma. The firm was
founded 5 years ago to provide educational software f
and secondary school rnarkets. Although EduSoft has done well, the firm's founder
believes an industry shakeout is irnminent. To surwive, EduSoft must grab market share
now, and this will require a large infusion of new capital.
Because he expects earnings to continue rising sharply and looks for the stock price to
follow suit, Mr. Duncan does not think it lvouid be wise to issue new common stock at
this time. On the other hand, interest rates are currently high by historical standards, and
the firm's B rating means that interest payments on a nerv debt issue nould be prohibitive.
Thus, he has narrowed his choice offinancing alternatives to (l) preferred stock, (2) bonds
with warrants, or (-l) convertible bonds.
As Duncan's assistant, you have been asked to help in the decision process by
ansu,ering the following questions.
a. How does preferred stock differ from both common equity and debt? Is preferred
stock more risky than common stock? What is floating rate preferred stock?
b. How can knowledge of call options help a financial manager to better understand
warrants and convertibles?
c. Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and
focus on the others. EcluSoll's investment banker estimates that EduSoft could issue a
bond-with-warrants package consisting of a 2O-year bond and 27 warrants. Each
warrant would have a strike price of $25 and l0 years until expiration. It is estimated
that each rvarrant, when detached and traded separately, would have a value of $5.
The coupon on a similar bond but without warrants would be 10%.
(l) What coupon rate should be set on the bond with warrants if the total package is
to sel1 at par ($1,000)?
(2) When would you expect the warrants to be exercised? What is a stepped-up exercise
price?
(3) Will the warrants bring in additional capital when exercised? If EduSoft issues
100,000 bond-with-warrant packages, how much cash will EduSoft receive when
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