Managerial Finance

Do.,.rY Y^:.,^,o",,",!,''u

r-l hi okfu9 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<lr the rapidly expanding primary 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

, ktl