As an alternative to the bond with warrants, Mr. Duncan is considering convertible bonds. The firms investment

Question:

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% coupon (paid annually), callable convertible bonds for its $1,000 par value, whereas a straight-debt issue would require a 10% coupon (paid annually) 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 it a constant 8% 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?

(2) What is the convertible’s straight-debt value? What is the implied value of the convertibility feature?

(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?

(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?

(5) Assume EduSoft intends to force conversion by calling the bond as soon as possible after its conversion value exceeds 20% above its par value, or 1.2($1,000) = $1,200. When is the issue expected to be called?

(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?

Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 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 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 two securities:

(1) Bonds with warrants or

(2) Convertible bonds. As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions:

Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of... Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Dividend
A dividend is a distribution of a portion of company’s earnings, decided and managed by the company’s board of directors, and paid to the shareholders. Dividends are given on the shares. It is a token reward paid to the shareholders for their...