Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept; and although Fish & Chips has done well, the firm’s founder and chairman believes that an industry shake-out is imminent. To survive, the firm must capture market share now, which requires a large infusion of new capital.
Because the stock price may rise rapidly, Millon does not want to issue new common stock. On the other hand, interest rates are currently very high by historical standards; and with the firm’s B rating, the interest payments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answering the following questions.
a. How does preferred stock differ from common equity and debt?
b. What is adjustable-rate preferred?
c. How can a knowledge of call options help a person understand warrants and convertibles?
d. One of Millon’s alternatives is to issue a bond with warrants attached. Fish & Chips’ current stock price is $10, and the company’s investment bankers estimate its cost of 20year annual coupon debt without warrants to be 12%. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise price of $12.50. It is estimated that each warrant, when detached and traded separately, will have a value of $1.50.
(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 are issued and the warrants immediately trade for $2.50 each. What does this imply about the terms of the issue? Did the company “win” or “lose”?
(3) When would you expect the warrants to be exercised?
(4) Will the warrants bring in additional capital when exercised? If so, how much and what type of capital?
(5) Because warrants lower the cost of the accompanying debt, shouldn’t all debt be issued with warrants? What is the expected cost of the bond with warrants if the warrants are expected to be exercised in 5 years, when Fish & Chips’ stock price is expected to be $17.50? How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock?
e. As an alternative to the bond with warrants, Millon is considering convertible bonds. The firm’s investment bankers estimate that Fish & Chips could sell a 20-year, 10% annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 12% coupon. Fish & Chips’ current stock price is $10, its last dividend was $0.74, and the dividend is expected to grow at a constant rate of 8%. The convertible could be converted into 80 shares of Fish & Chips stock at the owner’s option.
(1) What conversion price, Pc, is implied in the convertible’s terms?
(2) What is the straight-debt value of the convertible? What is the implied value of the convertibility feature?
(3) What is the formula for the bond’s conversion value in any year? Its value at Year 0? At Year 10?
(4) What is meant by the term “floor value” of a convertible? What is the convertible’s expected floor value in Year 0? In Year 10?
(5) Assume that Fish & Chips intends to force conversion by calling the bond when its conversion value is 20% above its par value, or at 1.2($1,000) = $1,200. When is the issue expected to be called? Answer to the closest year.
(6) What is the expected cost of the convertible to Fish & Chips? Does this cost appear consistent with the riskiness of the issue? Assume conversion in Year 5 at a conversion value of $1,200.
f. Millon believes that the costs of both the bond with warrants and the convertible bond are essentially equal, so her decision must be based on other factors. What are some factors she should consider when making her decision?