Tulsa Drilling Company has $1 million in 11 percent convertible bonds outstanding. Each bond has a $1,000 par value. The conversion ratio is 40, the stock price is $32, and the bonds mature in 10 years. The bonds are currently selling at a conversion premium of $70 over the conversion value.
a. If the price of Tulsa Drilling Company common stock rises to $42 on this date next year, what would your rate of return be if you bought a convertible bond today and sold it in one year? Assume that on this date next year, the conversion premium has shrunk from $70 to $20.
b. Assume the yield on similar nonconvertible bonds has fallen to 8 percent at the time of sale. What would the pure bond value be at that point? (Use semiannual analysis.) Would the pure bond value have a significant effect on valuation then?