You are considering the purchase of a convertible bond issued by Bildon Enterpri

Question

You are considering the purchase of a convertible bond issued by Bildon Enterprises, a noninvestment- grade medical service firm. The issue has seven years to maturity and pays a semiannual coupon rate of 7.625 percent (i.e., 3.8125 percent per period). The issue is callable by the company at par and can be converted into 48.852 shares of Bildon common stock. The bond currently sells for $965 (relative to par value of $1,000), and Bildon stock trades at $12.125 a share. a. Calculate the current conversion value for the bond. Is the conversion option embedded in this bond in the money or out of the money? Explain. b. Calculate the conversion parity price for Bildon stock that would make conversion of the bond profitable. c. Bildon does not currently pay its shareholders a dividend, having suspended these distributions six months ago. What is the payback (i.e., break-even time) for this convertible security and how should it be interpreted? d. Calculate the convertible’s current yield to maturity. If a “straight” Bildon fixed-income issue with the same cash flows would yield 9.25 percent, calculate the net value of the combined options (i.e., the issuer’s call and the investor’s conversion) embedded in the bond

Explanation / Answer

a. The conversion value of the bond is calculated as :

Conversion value = Current market price of common stock * conversion ratio

Conversion value = 12.125 * 48.852 = $592.33

Since the conversion value is lower than the bond value, the conversion option embedded in this bond is out of the money.

b. Conversion parity price for Bildon stock = Market price of convertible bond / Conversion Ratio

Conversion parity price for Bildon stock = 965/48.852 = $19.7535

At a stock price of 19.7535, the conversion would be profitable.

c. Payback period is the time an investor takes to recover the premium paid for the convertible bond.

Premium = 19.7535 -12.125 = $7.6285

Income differntial per share = 1000*7.625% / 48.852 = 1.5608

Hence payback for this convertible security = 7.6285/1.5608 = 4.88 years

d. Current yield to maturity = rate(nper,pmt,pv,fv) in excel where nper = 7 years = 14 semi- annual periods, pmt = 3.8125% *1000 = 38.125, pv = 965 and fv =1000

Hence semi-annual yield to maturity = rate(14,38.125.-965,1000) = 4.1471%

Annual yield to matuirty = 4.1471 *2 = 8.2942%

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