Warrant, Convertible decisions The Howland Carpet Company has grown rapidly duri

Question

Warrant, Convertible decisions The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $250,000, carrying an 8 percent interest rate. Howland has been 30 to 60 days late in paying trade creditors. Discussions with an investment banker have resulted in the decision to raise $500,000 at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored): Alternative 1: Sell common stock at $8. Alternative 2: Sell convertible bonds at an 8 percent coupon, convertible into 100 shares of common stock for each $1,000 bond (that is, the conversion price is $10 per share). Alternative 3: Sell debentures at an 8 percent coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.

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Explanation / Answer

I don't exactly what you are looking for, but without more data it is impossible to calculate the value of the warrants/convertible bonds. (We need to know that the market interest rate on bonds is or the volatility for the stock). Assuming the company can sell alternative 2 and 3 for the same price they should never do #3, this is because warrants give the owner the right to exercise when he wants. With convertible bonds the company can convert the bonds into stocks when it is beneficial for them. If they sell stock they would have to sell 500,000/8 = 62,500 shares. If they sell the convertible bonds they would have to sell 500,000/1,000 = 500 bonds that could be converted into 500*100 shares = 50,000 shares. If they sell the bonds and warrants they would again sell 500 bonds but since they are also selling warrants they would also sell the right to buy 50,000 shares at $10. From this alternative 2 definitely looks the best. The company could technically sell the bonds and convert them immediately and save 12,500 shares. Hope this helps.

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