Solved: Christine Guthrie was recently hired by S S Air Inc

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Christine Guthrie was recently hired by S&S Air Inc. to assist the company with its short-term
financial planning and to evaluate the company’s performance. Christine graduated from
university five years ago with a finance degree. She has been employed in the finance
department of a Fortune 500 company since then.

S&S Air was founded 10 years ago by two friends, Mark Sexton and Tammy Story. The
company has manufactured and sold light airplanes over this period, and the company’s
products have received excellent reviews for safety and reliability. The company has a niche
market in that it sells primarily to individuals who own and fly their own airplanes. The company
has two models: the Birdie, which sells for $53,000, and the Eagle, which sells for $78,000.

S&S Air is not publicly traded, but the company needs new funds for investment opportunities.
In consultation with Tony Jones of underwriter Raines and Warren, Christine decides that a
convertible bond issue with a 20-year maturity is the way to go. She meets with the owners,
Mark and Tammy, and presents her analysis of the convertible bond issue. Because the
company is not publicly traded, Christine looks at comparable publicly traded companies and
determines that the average price–earnings (P/E) ratio for the industry is 17.5. EPS for the
company is $1.75. With this in mind, Christine concludes that the conversion price should be
$45 per share.

Several days later, Tammy, Mark, and Christine meet again to discuss the potential bond issue.
Both Tammy and Mark have researched convertible bonds and have questions for Christine.
Tammy begins by asking Christine if the convertible bond issue will have a lower coupon rate
than a comparable bond without a conversion feature. Christine replies that to sell the bond at
par value, the convertible bond issue requires a 5 percent coupon rate with a conversion value
of $680.56, while a plain vanilla bond would have an 8 percent coupon rate. Tammy nods in
agreement, and she explains that the convertible bonds are a win–win form of financing. She
states that if the value of the company stock does not rise above the conversion price, the
company will have issued debt at a cost below the market rate (5 percent instead of 8 percent).
If the company’s stock does rise to the conversion value, the company will have effectively
issued stock at above the current value.

Mark immediately disagrees, arguing that convertible bonds are a no-win form of financing. He
argues that if the value of the company stock rises to $45, the company is forced to sell stock at
the conversion price. This means the new shareholders (those who bought the convertible
bonds) benefit from a bargain price. Put another way, if the company prospers, it would have
been better to have issued straight debt so that the gains would not be shared.

Christine goes back to Tony for help. As Tony’s assistant, you are asked to prepare another
memo answering the following questions:

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 1. Why do you think Christine is suggesting a conversion price of $45? Given that the company
is not publicly traded, does it even make sense to talk about a conversion price?

2. What is the floor value of the S&S Air convertible bond?

3. What is the conversion ratio of the bond?

4. What is the conversion premium of the bond?

5. What is the value of the option?

6. Is there anything wrong with Tammy’s argument that it is cheaper to issue a bond with a
convertible feature because the required coupon is lower?

7. Is there anything wrong with Mark’s argument that a convertible bond is a bad idea because
it allows new shareholders to participate in gains made by the company?

8. How can you reconcile the arguments made by Tammy and Mark?

9. During the debate, a question comes up concerning whether the bonds should have an
ordinary (not Canada plus) call feature. Christine confuses everybody by stating, “The call
feature lets S&S Air force conversion, thereby minimizing the problem Mark has identified.”
What is she talking about? Is she making sense?

Christine Guthrie was recently hired by S S Air Inc to

ANSWER
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