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7
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SOLUTION TO SPREADSHEET PROBLEM
website, in whole or in part.
MINI CASE
Paul Duncan, financial manager of Edusoft Inc., is facing a dilemma. The firm was
founded five years ago to provide educational software for the rapidly expanding primary
and secondary school markets. Although Edusoft has done well, the firm’s founder
believes that an industry shakeout is imminent. To survive, 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 would be wise to issue new common stock at this
time. On the other hand, interest rates are currently high by historical standards, and with
the firm’s B rating, the interest payments on a new debt issue would be prohibitive. Thus,
he has narrowed his choice of financing alternatives to: (1) preferred stock; (2) bonds with
warrants; or (3) convertible bonds.
As Duncan’s assistant, you have been asked to help in the decision process by answering
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?
omitted without putting the company into default and thus into bankruptcy. Note,
however, that the provisions of most preferred stock issues prevent a firm from
spectrum. Floating rate preferred stock has a dividend payment that is indexed to the
rate on treasury securities, so it almost always trades at par.
Mini Case: 20 - 14
b. What is a call option? How can knowledge of call options help a financial
manager to better understand warrants and convertibles?
implied call option. If financial managers understand how call options are valued,
they can make better decisions regarding the structuring of warrant and convertible
issues.
c. Mr. Duncan has decided to eliminate preferred stock as one of the alternatives
and focus on the others. EduSoft’s investment banker estimates that EduSoft
could issue a bond-with-warrants package consisting of a 20-year bond and 27
warrants. Each warrant would have a strike price of $25 and 10 years until
expiration. It is estimated that each warrant, when detached and traded
separately, would have a value of $5. The coupon on a similar bond but without
warrants would be 10%.
1. What coupon rate should be set on the bond with warrants if the total package is
to sell for $1,000?
Answer: If the entire package is to sell for $1,000, then
using a financial calculator, enter N = 20, I = 10, PV = -865, and FV = 1,000 to solve
Mini Case: 20 - 15
c. 2. When would you expect the warrants to be exercised? What is a stepped-up-
exercise price?
Answer: Generally, a warrant will sell in the open market at a premium above its expiration
in equity capital, some warrants contain step-up provisions, whereby the strike price
(also called the exercise price) increases in steps over the life of the warrant. Since
warrant will fall if the stock price falls, and stock prices fall when the stock goes ex
dividend. If the dividend is large, warrant holders can avoid recurring large losses by
exercising.
Mini Case: 20 - 16
c. 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
the warrants are exercised? How many shares of stock will be outstanding after
the warrants are exercised? (EduSoft currently has 20 million shares
outstanding).
Answer: When exercised, each warrant will bring in an amount equal to the strike price, which
Data:
Number of warrants/bond = 27
Number of bonds = 100,000
Strike price = $25
Mini Case: 20 - 17
c. 4. Because the presence of warrants causes a lower coupon rate on the
accompanying debt issue, shouldn’t all debt be issued with warrants? To answer
this, estimate the expected stock price in 10 years when the warrants are
expected to be exercised, then estimate the return to the holders of the bond-
with- warrants packages. Use the corporate valuation model to estimate the
expected stock price in 10 years. Assume that EduSoft’s current value of
operations is $500 million and it is expected to grow at 8% per year.
Answer: Even though the 8.4 percent coupon rate on the bond is below the 10 percent coupon
3. Find rBwW as the weighted combination of the expected returns on straight debt
of 8% per year.
Vop,10 = Vop,0 (1+g)10
