978-1305637108 Chapter 20 Solution Manual Part 2

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SOLUTION TO SPREADSHEET PROBLEM

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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