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20-2 Preferred stock is best thought of as being somewhere between debt (bonds) and equity
(common stock). Like debt, preferred stock imposes a fixed charge on the firm, affords
its holders no voting rights, and has priority over common stock in the event of
bankruptcy. However, like equity, its payments are considered dividends from both legal
and tax standpoints, it has no maturity date, and it is carried on the firms balance sheet in
the equity section. From a creditors viewpoint, preferred stock is more like common
stock, but from a common stockholders standpoint, preferred stock is more like debt.
20-3 The trend in stock prices subsequent to an issue influences whether or not a convertible
issue will be converted, but conversion itself typically does not provide a firm with
additional funds. Indirectly, however, conversion may make it easier for a firm to get
additional funds by lowering the debt ratio, thus making it easier for the firm to borrow.
In the case of warrants, on the other hand, if the price of the stock goes up sufficiently,
the warrants are likely to be exercised and thus to bring in additional funds directly.
20-4 Either warrants or convertibles could be used by a firm that expects to need additional
financing in the future--warrants, because when they are exercised, additional funds will
be brought into the firm directly; convertibles, because when they are converted, the
equity base is expanded and debt can be sold more easily. However, a firm that does not
have additional funds requirements would not want to use warrants.
20-5 a. The value of a warrant depends primarily on the expected growth of the underlying
stocks price. This growth, in turn, depends in a major way on the plowback of
earnings; the higher the dividend payout, the lower the retention (or plowback) rate;
hence, the slower the growth rate. Thus, warrant values will be higher, other things
held constant, the smaller the firms dividend payout ratio. This effect is more
pronounced for long-term than for short-term warrants.
20-7 The convertible bond has an expected return which consists of an interest yield (10
percent) plus an expected capital gain. We know the expected capital gain must be at
least 4 percent, because the total expected return on the convertible must be at least equal
to that on the nonconvertible bond, 14 percent. In all likelihood, the expected return on
the convertible would be higher than that on the straight bond, because a capital gains
yield is riskier than an interest yield. The convertible would, therefore, probably be
regarded as riskier than the straight bond, and rc would exceed rd. However, the
convertible, with its interest yield, would probably be regarded as less risky than common
stock. Therefore, rd < rc < rs.
20-1 Bonds with warrants: $1,000 par value 15-year 5% coupon bonds with annual payments,
trading for $1,000.
Straight debt: $1,000 par value 15-year bonds with 7% annual coupon, also trading for
$1,000.Value of warrants = ?
Straight debt yield = coupon rate = 5% since these bonds are trading at par. Note, if the
bonds were not trading at par youd need to calculate the yield to maturity.
20 20
I $1,000 I $1,000
$850 = t
20
= t
t 1 (1 rd ) (1 rd ) t 1 (1.12 ) (1.12) 20
With a financial calculator, N = 20; I/YR = 12; PV = 850; FV = 1000; solve for
PMT = 99.92 $100. Therefore, the company would set a coupon interest rate of 10
percent, producing an annual interest payment I = $100.
20-5 a. The premium of the conversion price over the stock price was 14.1 percent:
$62.75/$55 - 1.0 = 0.141 = 14.1%.
However, the after-tax interest savings would be more relevant to the firm and would
be calculated as $12,000,000(1 - T).
c. At the time of issue, the value of the bond as a straight bond was $669.11, calculated
as follows: N = 40, I/YR = 8.75, PV = ?, PMT = 57.5, FV = 1000. Solving, PV = -
669.11. Notice that this implies that the value of the conversion feature at the time of
issue was $331.89 = $1,000 - $669.11.
d. If interest rates had not changed, then the value of the straight bond fifteen years after
issue would have been $699.25, calculated as follows: N = 25, I/YR = 8.75, PV = ?,
PMT = 57.5, FV = 1000. Solving, PV = -699.25.
Assuming that the stock had not gone above $62.75 during the fifteen years after it
was issued, the bond would not have been converted. For example, if a bondholder
converted the bond, the bondholder would receive about 15.9 shares of stock per
bond, calculated as follows:
If the stock price is $32.75, then the value of the bond in conversion is
15.936255($32.75) = $521.91.
Because the value in conversion is less than the value as a bond, investors would not
wish to convert the bond.
e. The value of straight bond would have increased from $669.11 at the time of issue to
$699.25 fifteen years later, as calculated above, due to the fact that the bonds are
closer to maturity (because a bonds value approaches its par value as it gets closer to
maturity). However, the value of the conversion feature would have fallen sharply,
for two reasons. First, the stock price fell from $55 to $32.75, and a decrease in stock
price hurts the value of an option. Second, the time until maturity for the conversion
fell from 40 years to 25 years, and a reduction in the remaining time to exercise an
option hurts its value. Therefore, the bonds probably would have fallen below the
$1,000 issue price.
f. Had the rate of interest fallen to 5.75 percent, which is the coupon rate on the bonds,
then their straight bond value would be that of a par bond, which is $1,000. This can
also be calculated as follows: N = 25, I/YR = 5.75, PV = ?, PMT = 57.5, FV = 1000.
Solving, PV = -1,000.
Although the value of the conversion feature would have dropped in value due to the
decline in stock price and the decrease in the remaining time for the conversion to be
exercised, the value of the conversion feature would still have a positive value
(because an option value can never be zero or below). Therefore, the bonds would
probably have a price slightly above their par value of $1,000.
20-7 a.
Stock data and stock required return:
rd = 9%.
P0 = $23.
D0 = $2.
g = 6%.
rs = $2.12/$23.00 + 6% = 15.22%.
We need to find the number of years that it takes $805 to grow to $1,200 at a 6% interest
rate. Using a financial calculator, I/YR = 6, PV = 805, PMT = 0, FV = -1200; solving, N
= 6.852. So the call will be at the first year end after this, or at Year 7.
20
$80 $1,000
V = (1 0.09)
t 1
t
(1 0.09) 20
= $908.715.
Repeating, we can find the straight bond value for different values of N:
V at t = 5 (N = 15): $919.39.
V at t = 10 (N = 10): $935.82.
V at t = 15 (N = 5): $961.10
V at t = 20 (N = 0): $1,000.
Conversion value:
The stock price should grow at the 6%. The conversion value at Year t is equal to the
expected stock price multiplied by the conversion ratio:
CVt = P0(1.06)N(35).
For the expected time of conversion (N = 7), the conversion value is:
The cash flow at the time of conversion (N = 7), is equal to the conversion value plus the
coupon payment:
7
$80 $1,210.42
b. $1,000 = (1 r ) (1 rc )
.
t 1 c