One of the firms alternatives is to issue a bond with warrants attached. EduSofts current stock price
Question:
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 EduSoft could issue a 20-year bond without warrants at a coupon rate of 10% paid annually. 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?
(5) Because warrants lower the cost of the accompanying debt issue, shouldn’t all debt be issued with warrants? What is the expected return to the holders of the bond with warrants (or the expected cost to the company) if the warrants are expected to be exercised in 10 years EduSoft’s stock price is currently $20 per share and is expected to grow at 8% per year. 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?
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 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:
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Expected Return
The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these...
Step by Step Answer:
1 If the entire package is to sell for 1000 then V package V bond V warrants 1000 The 45 warrants each have an estimated value of 3 so V warrants 453 135 thus V bond 150 1000 865 Therefore the bonds m...View the full answer
