Defense Systems Inc. has convertible bonds outstanding that are callable at $1,070. The bonds are convertible into 33 shares of common stock. The stock is currently selling for $39.25 per share.
a. If the firm announces it is going to call the bonds at $1,070, what action are bondholders likely to take and why?
b. Assume that instead of the call feature, the firm has the right to drop the conversion ratio from 33 down to 30 after 5 years and down to 27 after 10 years. If the bonds have been outstanding for four years and 11 months, what will the price of the bonds be if the stock price is $40? Assume the bonds carry no conversion premium.
c. Further assume that you anticipate that the common stock price will be up to $42.50 in two months. Considering the conversion feature, should you convert now or continue to hold the bond for at least two more months?