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A B C D E F G H I
Solution 12/8/2012
Chapter: 20
Problem: 9
Inputs:
7%
$22.00
7%
4%
1,250.00$
Year
Anticipate
d stock
price at
year end
(1)
Conversion
Value
(2)
Convert?
(Yes, no, or
already)
Straight debt
value of
convertible
(3)
Cash flow to
bondholder
if converted
(4)
0 22.00 704.00 $894.06 -$1,000.00
1 23.54 753.28 No $896.64 $60.00
Maggie's Magazines (MM) has straight nonconvertible bond that currently yield 9%. MM's stock sells for $22 per share,
has an expected constant growth rate of 6%, and has a dividend yield of 4$. MM plans on issuing convertible bonds
that will have a $1,000 par value, a coupon rate of 8%, a 20-year maturity, and a conversion ratio of 32 (i.e., each bond
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 $1,90; this call price would decline by $6 per year in Year 6
and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year,
immediately after the coupon and dividend payments. Management will call the bonds when the bonds’ conversion
value exceeds 25% of the bonds’ par value (not their call price).
a. For each year, calculate: (1) the anticipated stock price; (2) the anticipated conversion value; (3) the anticipated
straight-bond price; and (4) the cash flow to the investor assuming conversion occurs. At what year do you expect the
bonds will be forced into conversion with a call? What is the bond’s value in conversion when it is converted at this
time? What is the cash flow to the bondholder when it is converted at this time (Hint: the cash flow includes the
conversion value and the coupon payment, because the conversion is immediately after the coupon is paid.)
Will call the issue in the first year that the conversion
Straight bond yield
Current stock price
Expected growth rate in stock price
Dividend yield
61
62
63
64
65
66
67
68
69
70
76
77
78
79
80
81
82
83
84
85
Conversion year = 9
Value in conversion = 1,294.28$
b. What is the expected rate of return (i.e., before-tax component cost) on the proposed convertible issue?
Using the RATE function:
N = 9
As a check, using the IRR function and the cash flows in column F:
Expected return to bondholders 8.325%
Expected return required by convertible bondholders =
9%
c. Assume that the convertible bondholders require a 9% rate of return. If the coupon rate remains
unchanged, then what conversion ratio will give a bond price of $1000?
