Question

You own one $1,200 convertible debenture of Nata Co. at an interest rate of 10%. The convertible debenture is convertible into common shares of Nata at $60 per share. Nata common is a perennial hot stock. At the time of the issuance of the debenture, the shares were trading at $40 per share. Nata earned $6.00 per share last year and paid an annual dividend of $1.00 last year. Earnings and dividends have been rising at about 18% per year for the past 10 years, and you expect this growth to continue. You perceive numerous risks, however, and believe a risk premium of 6% over U.S. Treasuries, which currently are selling at 8%, is appropriate. You plan to hold the stock for one year and expect you can resell the stock at a price between $75-$78 next year.

(a) (10%) Would you buy the shares at $70 or choose to convert your debenture into common shares now? Why?

For questions (b) and (c), consider the following additional facts: Nata is considering an investment opportunity that will generate 21% return on invested capital. The associated risks make a risk premium of 12% over U.S. Treasuries more appropriate for Nata.

(b) (10%) Would you convert your debenture into common shares? If you convert, would you resell the stock next year or hold it perpetually?

(c) (10%) Should Nata skip this year’s dividend to invest? Why?

Answer 1

Given

One Convertible Debenture = 1200 dollars

Interest Rate = 10%

Option given to buy shares at 60 dollars per share

Growth = 18% till perpetuity

Market Risk Premium = 6% over risk free rate

Risk Free rate = 8%

(a)

I will recieve one share at the rate of 60 dollars

I have convertible debenture worth 1200 dollars

Number of shares i get after converting debenture into shares = 1200/60 = 20 shares

If i am getting shares at 60 dollar per share why will i purchase the share at 70 dollars in the open market.

Definetly i would convert my debentures into shares and sell the shares whenever i feel the price is high to the maximum extent.

(b)

It is given that Nata is considering an Investment that will generate 21% return on Invested Capital which results in increase in risk premium to 12 % from 6% in the previous case.

Since company is going to invest in project which will give higher return because of taking higher risk, i would definetly convert my debentures into shares

Whether i will sell in next year or held it till perpetuity depends on factors such as need of money.

OPTION 1: If i want to get a whole lot of sum in future i will not sell the stock now because the grwoth prospects are good for the company.

OPTION 2: If I dont want to take risk of suncertainity of future then i would sell the share next year.

(c)

Yes, Nata Company can skip the dividend this year and invest in the projects because investment in projects gives better rate of return than usual to the equity shareholders of the company.

The company will have good growth prospects in near future if they are investing and it will yield higher return to equity shareholders rather more than dividend they get.