Question

3. Irving Electronics is considering the issuance of a 20-year convertible bond that will be priced at par value of $1,000 per bond. The bonds carry a 12% annual coupon interest rate and can be converted into 40 common shares. The shares are currently priced at $20 per share, with an expected annual dividend of $3 and is growing at a constant 5% annual rate. The bonds are callable after 10 years at $1,050, with the price declining by $5 per year. If, after 10 years, the conversion exceeds the call price by at least 20%, management is likely to call the bonds. What is the conversion price?

4. Refer to problem 3 above. If the yield-to-maturity on the non-convertible bonds of similar risk is 16%, what is the straight debt value of this convertible bond?

5. Refer to problem 3 above. If an investor expects the bond issue to be called in year 10 and he or she plans on converting it at that time, what is the investor’s expected rate of return upon conversion?

Answer 1

a) Conversion Price = Par Value/Shares = $1,000/40 = $25

b) We can get the debt value of the convertible bond using PV function in excel:

No of periods(Nper) = 20

Rate = 16%

Pmt(Payment per period) = 12% * $1,000 = $120

FV = $1,000

Formula Used: =-PV(16%,20,120,1000)

PV = $762.85

Therefore, straight debt value of the convertible bond is $762.85

c) The stock's market value in Year 10 will be $20 * 1.05¹⁰ * 40 = $1,303.12

Call price = $1050

Call price exceeded by 20% = 1050 * 1.2 = $1,260

Therefore, stock's market value in year 10 exceeds call price by atleast 20%

Investor initially paid $1000, received coupon of $120 for 10 years and received conversion value of $1303.12 in year 10 when management calls the bonds.

Using IRR function in excel:

Therefore, investor's expected rate of return upon conversion = 13.6%