Security Software, Inc.
Case 33
Convertibles
Purpose: The case allows the student to view the hybrid nature of convertible securities. While it would
be very difficult for the firm to issue either equity or bonds in a post-recession bear market, convertible
securities offer the opportunity to enter the market at a lower interest rate and at a higher conversion
price than the stock price the firm currently has. However, the case also illustrates the potentially
downward effect of convertibles on earnings per share. An interesting feature of the case is that it traces
stock price declines during the Internet bust.
Relation to Text: The case should follow Chapter 19.
Complexity: The case is moderately complex. It should require 1 to 1½ hours.
Solutions
1.
a.
$30
Million …………………………………………………..
Par value
7.5%
……………………………………………………………..
Interest rate
$2.25
Million …………………………………………………..
Interest
4.
$30
Million …………………………………………………..
Total issue
3.5%
……………………………………………………………..
Interest savings
$1,050,000
……………………………………………………………..
Annual interest savings
`
5. With a conversion ratio of 40, the bonds will go up to a value of at least $1,400 (40 x $35). A
6. The corporation could force a conversion through calling in the bonds at close to par when they are
trading well in excess of par. In order to avoid the call at close to par, the bondholders would convert
7.
a.
Earnings before interest and taxes ……………………………………………………………………………..
$15,000,000
Interest ($1,000,000 from the table in Question 7 plus $2,225,000 from the
answer to Question 1 ……………………………………………………………………………………………
3,225,000
Earnings before taxes ………………………………………………………………………………………………
$11,775,000
Taxes (30%) …………………………………………………………………………………………………………..
3,532,500
Earnings after taxes …………………………………………………………………………………………………
$ 8,242,500
Basic earnings per share =
Earnings after taxes
=
$8,242,500
= $.824
Shares of common stock
10,000,000
b.
Diluted earnings per share =
$8,242,500 + $1,557,500*
=
$9,800,000
= $.875
10,000,000 + 1,200,000
11,200,000
*
$2,225,000
(Question 1)
.70
(1– tax rate or 1– .30)
$1,557,500
8. The convertibles increase basic earnings per share by slightly over $.12 from $.70 to .824. Diluted
earnings per share are also up by $.175 from the initial value of $.70 to $.875. Although in this case,