Question 3: 3. What is your estimate of the coupon rate that the convertible bond should have?

Maanavi suspected that management would express concern that a 25% premium would be
sending a bad signal to the market: a low conversion premium could be interpreted as
management’s lack of confidence in the upside potential of the stock. For a five-year issue, the
stock would only need to rise by 5% per year to reach the conversion price by maturity. If
management truly believed the stock had strong appreciation potential, then the conversion
premium should be set much higher.
If Maanavi could convince MoGen to accept the 25% conversion premium, then choosing the
coupon rate was the last piece of the pricing puzzle to solve. Because he was proposing a mid-
range conversion premium, investors would be satisfied with a modest coupon. Based on
MoGen’s bond rating, the company would be able to issue straight five-year bonds with a 5.75%
yield. Therefore, Maanavi knew that the convertible should carry a coupon rate noticeably
lower than 5.75%. The challenge was to estimate the coupon rate that would result in the debt
being issued at exactly the face value of $1000 per bond.
Information given:
Current stock price: $77.98
Face value of bond: $1,000
Yield to maturity: 5.75%
# of years: 5
25% conversion premium:
Conversion ratio: 10.26
Conversion price: $97.48
Coupon payment (annually) $19.50
Coupon payment (semi-annually): $9.75
Coupon rate: 1.95%
30% conversion premium-recommend
Conversion ratio: $9.86
Conversion price: $101.37
Straight bond value: $ 769
Coupon payment (annually): $23.39
Coupon rate (semi): $11.70
Coupon rate: 2.34%

If the conversion premium was set above 40%, fundamental investors tended to lose interest
because the convertible became a more speculative investment with less upside potential. Thus,
if the conversion premium were set at 40% or higher, it could be necessary to offer an
abnormally high coupon rate for a convertible. In either case, Maanavi thought a high
conversion premium was not appropriate for such a large offering. It could work for a smaller,
more volatile stock, but not for MoGen and not for a $5 billion offering.

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