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c. 6. If the corporate tax rate is 40%, what is the after-tax cost of the bond with
warrants?
Answer: Because the bond portion of the package was issued at a discount (its value was only
There is no tax implication to the warrant exercise.
AT rBwW = ($865/$1,000)x(6.24%) + ($135/$1,000)x(15.73%)
AT rBwW = 7.52%
d. As an alternative to the bond with warrants, Mr. Duncan is considering convertible
bonds. The firm’s investment bankers estimate that Edusoft could sell a 20-year, 8.5
percent annual coupon, callable convertible bond for its $1,000 par value, whereas a
straight-debt issue would require a 10 percent coupon. The convertibles would be
call protected for 5 years, the call price would be $1,100, and the company would
probably call the bonds as soon as possible after their conversion value exceeds
$1,200. Note, though, that the call must occur on an issue date anniversary.
Edusoft’s current stock price is $20, its last dividend was $1.00, and the dividend is
expected to grow at a constant 8 percent rate. The convertible could be converted
into 40 shares of Edusoft stock at the owner’s option.
1. What conversion price is built into the bond?
Answer: Conversion Price = PC =
received Shares #
Par value
=
40
000,1$
= $25.
The conversion price is similar to a warrant’s strike price, and, as with warrants, the
conversion price is typically set at between 10 and 30 percent above the stock price
on the issue date.
website, in whole or in part.
d. 2. What is the convertible’s straight-debt value? What is the implied value of the
convertibility feature?
$872.30 = $127.70. The convertibility value is analogous to the price on a warrant.
d. 3. What is the formula for the bond’s expected conversion value in any year?
What is its conversion value at year 0? At year 10?
And, hence, for year 0 and year 10, we have the following:
Year 0: CV0 = 40($20)(1.08)0 = $800.
Year 10: CV10 = 40($20)(1.08)10 = $1,727.14.
d. 4. What is meant by the “floor value” of a convertible? What is the convertible’s
expected floor value at year 0? At year 10?
Mini Case: 20 - 21
$1,727 is clearly higher than the straight-debt value, and hence the conversion value
d. 5. Assume that Edusoft intends to force conversion by calling the bond as soon as
possible after its conversion value exceeds 20 percent above its par value, or
1.2($1,000) = $1,200. When is the issue expected to be called? (Hint: recall that
the call must be made on an anniversary date of the issue.)
one. However, the HP-17b gives the unrounded answer 5.27.)
d. 6. What is the expected cost of capital for the convertible to Edusoft? Does this cost
appear to be consistent with the riskiness of the issue?
0 1 2 3 4 5 6
| | | | | | |
0P
)g1(D
)08.1(00.1$
of equity, so rc should fall between the cost of debt and equity. Thus, the 11.84
d. 7. What is the after-tax cost of the convertible bond?
Mini Case: 20 - 23
e. Mr. Duncan believes that the costs of both the bond with warrants and the
convertible bond are close enough to one another to call them even, and also
consistent with the risks involved. Thus, he will make his decision based on
other factors. What are some of the factors which he should consider?
Answer: One factor that should be considered is the firm’s future needs for capital. If Edusoft
converted.
Another factor is whether Edusoft wants to commit to 20 years of debt at this
f. How do convertible bonds help reduce agency costs?
Answer: Agency costs can arise due to conflicts between shareholders and bondholders, in the
cost.
will likely be converted into equity, which is what the company wants to issue.
