Question 2 Your firm wants to issue more equity but finds it costly to do so bec

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Question 2 Your firm wants to issue more equity but finds it costly to do so because of investment banking fees and the adverse selection problem associated with equity issuances. Given this, you decide to issue convertible bonds because you believe that the stock price will significantly appreciate in the future, implying a high likelihood of conversion. That is, you plan to issue equity indirectly by raising money via the convertible bond market. You raise capital by selling convertible bonds at $1,250 per bond. Each bond has a face value of $1,000, a coupon rate of 4 percent, and a 5 year maturity. The bonds can be exchanged at any time for 50 shares. The expected return on historical straight debt in your firm has been 5 percent. There is currently no other debt outstanding. a) What is the value of each bond's conversion option? (Hint:first find the value of the straight bond component of the convertible bond.) b) What is the minimum stock price that will induce the bondholders to convert their bonds into stock on the day before maturity? c) There are 1.2M shares outstanding and 8,000 convertible bonds outstanding. What is the minimum value of the firm that will induce the bondholders to convert their bonds into stock on the day before maturity? d) Draw the payoff diagram for the convertible bondholders as a function of the firm value. Specify the slopes of the lines that you draw. e) Draw the payoff diagram for the current shareholders as a function of firm value. Specify the slopes of the lines that you draw.

Explanation / Answer

Inputs for the straight bond Face Value of Bond = 1000 Coupon Rate on Bond = 4.00% Frequency of coupons = 1 Time to Maturity = 5 Interest Rate on Bond = 5.00% PV of immediate coupons = Price of Bond = $       956.71 Inputs for the straight bond Face Value of Bond = 1000 Coupon Rate on Bond = 4.00% Frequency of coupons = 1 Time to Maturity = 5 Interest Rate on Bond = 5.00% PV of immediate coupons = Price of Bond = $       956.71

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