Since 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 five years, when Edusoft’s stock price is expected to be $36.75? 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?

MINI CASE 

Paul Duncan, financial manager of Edusoft Inc., is facing a dilemma. The firm was founded five 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: