Convertible Bond Analysis Niendorf Incorporated needs to raise $2S million to construct production facilities for a new type of USB memory device. The firm’s straight nonconvertible debentures currently yield 9%. Its stock sells for $23 per share and has an exposed constant growth rate of 6%. Investment bankers have tentatively proposed that the firm raise the $25 million by issuing convertible debentures. These convertibles would have a $1,000 par value carry a coupon rate of 8%, have a 20-year maturity, and be convertible into 35 shares of stock. Coupon payments would be made annually. The bonds would be non-callable for 5 years, after which they would be callable at a price of $1,075; this call price would decline by $5 per year in Year 6 and each year thereafter. For simplicity, assume the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Assume management would call eligible bonds if the conversion value exceeded 20% of par value (not 20% of call Price).

a. 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.

b. What is the expected rate of return i.e., before-tax component cost) on the proposed convertible issue?