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 that 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:
a. How can knowledge of call options help a financial manager to better understand warrants and convertibles?
b. One of the firm's alternatives is to issue a bond with warrants attached. EduSoft's current stock price is $20, and its investment banker estimates that the cost of a 20-year, annual coupon bond without warrants would be 10%. The bankers suggest attaching 45 warrants, each with an exercise price of $25, to each $1,000 bond. It is estimated that each warrant, when detached and traded separately, would have a value of $3.
1. What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000?
2. Suppose the bonds were issued and the warrants immediately traded on the open market for $5 each. What would this imply about the terms of the issue? Did the company "win" or "lose"?
3. When would you expect the warrants to be exercised? Assume they have a 10-year life; that is, they expire 10 years after issue.
4. Will the warrants bring in additional capital when exercised? If so, how much, and what type of capital?
c. 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% annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 10% 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, and the dividend is expected to grow at 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 that 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? (Hint: Recall that the call must be made on an anniversary date of the issue.)
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?
d. 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 that he should consider?
e. How do convertible bonds help reduce agency costs?