II$.$ Background Information

Maggie's Magazines $($MM$)$ has straight nonconvertible bonds that currently yield $9\%.$

MM$\text{'}$s stock sells for $$22$ per share, has an expected growth rate of $6\%,$ and a dividend

yield of $4\%.$ MM plans on issuing convertible bonds that will have a $$1,000$ par value, a

coupon rate of $8\%,$ a $20-$year maturity, and a conversion ratio of $32.$ Coupon payments

will be made annually. The bonds will be noncallable for $5$ years, after which they will be

callable at a price of $$1,090$; this call price would decline by $$6$ per year in Year $6$ and

each year thereafter. For simplicity, assume that the bonds may be called or converted

only at the end of a year, immediately after the coupon and dividend payments.

Management will call the bonds when their conversion value exceeds $25\%$ of their par

value. Page $828$ SPREADSHEET PROBLEM $20-8$ Brigham$/$Ehrhardt$\text{'}$s $13$e

a$.$ For each year, calculate $(1)$ the anticipated stock price, $(2)$ the anticipated

conversion value, $(3)$ the anticipated straight$-$bond price, and $(4)$ the cash flow to

the investor assuming conversion occurs. At what year do you expect the bonds

will be forced into conversion with a call? What is the bond's$\_$value in conversion

when it is converted at this time? $($Hint: The cash flow includes the conversion

occurs immediately after the coupon is paid.$)$

b$.$ What is the expected rate of return $($i$.$e$.,$ the before$-$tax component cost$)$ on the

proposed convertible issue?

c$.$ Assume that the convertible bondholders require a $9\%$ rate of return. If the

coupon rate remains unchanged, then what conversion ratio will give a bond price

of $$1,000?$