Five years ago, Cayman’s Crafters, Inc. issued new 25 year convertible bonds wit
ID: 2713112 • Letter: F
Question
Five years ago, Cayman’s Crafters, Inc. issued new 25 year convertible bonds with a 4% coupon rate, compounded semi-annually. The bond has a par value of 10,000. The market’s required rate of return on similar securities at the time of issuance was 3.8%, compounded semi-annually. The bond indenture indicates that conversion ratio is 175, that is 1 bond can be converted in to 175 shares of Cayman’s common stock. Today, the yield to maturity on 20 year bonds is 2.6%, compounded semi-annually and 2.8%, compounded semi-annually on 25 year bonds. The current market price of the stock is $65. You purchased the bond 5 years ago. Decide whether you should convert the bond today or sell it today. Based on your decision, calculate the rate of return you earned while holding the bond over the 5 year period?
Explanation / Answer
Semi Annual Coupon on the bond = 4%/2 * 10000 = $200
YTM = 2.6%
No of periods = 20 * 2 = 40
If the bond does not get converted
Value of the Bond Today (using PV function of excel) =PV(2.6%/2,40,200,10000) = $12,172.61
Now, if the bond gets converted, it will be converted into 175 shares.
Price of 1 share = $65
Price of 175 share = 65 * 175 = $11,375
Since the value of bond if not converted is more than the value of the shares if converted, we should not convert the bond into stock and sell it today.
At the time of issuance, YTM = 3.8%
Price of the bond at issuance (using the PV function of excel) =PV(3.8%/2,50,200,10000)
= $10,320.95
5 year Holding Period Return
= (Coupon Payments + Current Price - Purchase Price)/Purchase Price
= (200 * 10 + 12172.61 - 10320.95)/10320.95 = 37.32%
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