Niendorf Incorporated needs to raise $25 million to construct production facilities for a new type of diskette drive. The firm’s straight nonconvertible debentures currently yield 14 percent. Its stock sells for $30 per share; the last dividend was $2; and the expected growth rate is a constant 9 percent. 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 10 percent, have a 20-year maturity, and be convertible into 20 shares of stock. 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. Management has called convertibles in the past (and presumably it will call them again in the future), once they were eligible for call, when the bonds’ conversion value was about 20 percent above the bonds’ par value (not their call price).
a. Draw an accurate graph similar to Figure 21-1 representing the expectations set forth above. (Assume an annual coupon.)
b. What is the expected rate of return on the proposed convertible issue?
c. Do you think that these bonds could be successfully offered to the public at par? That is, does $1,000 seem to be an equilibrium price in view of the stated terms? If not, suggest the type of change that would have to be made to cause the bonds to trade at $1,000 in the secondary market, assuming no change in capital market conditions.
d. Suppose the projects outlined here work out on schedule for 2 years, but then the firm begins to experience extremely strong competition from Japanese firms. As a result, Niendorf’s expected growth rate drops from 9 percent to zero. Assume that the dividend at the time of the drop is $2.38. The company’s credit strength is not impaired, and its value of rs is also unchanged. What would happen (1) to the stock price, and (2) to the convertible bond’s price? Be as precise as you can.