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

Ans:

a) Nata issued a convertible debenture to you for a $1200 @10% interest rate (Issued at the rate of $40 per share). These debentures are convertible when the share price reaches $60.

The conversion ratio of debenture = $1200 / $40 = 30 i.e. 30 shares of Nata will be allotted to you when the share price will reach $60 if you exercise your option. The total value of an investment will become 30*60 = $1800

Last year EPS = $6 / share and Dividend : $1/share. Hence retained earnings at $5 after paying the dividend.%

The expectation of earning and dividend growth = g = 18%.

Return on the stock due to DDM = r

Divident next year = D1 = $1

Initial price = P0 = $60

r = (D1/P0) + g

r = 1/60 + 0.18 = 0.017 +0.18 = 19.67%

Considering Beta as 1, the expected return on stock = Market risk + risk free rate = 6% +8% = 14%

Based on above, the return on equity based on the divident is more then the expected risk. Hence, you would not purchase the share at $70 but convert the debentures now.

b) The investment opportunity is 21% return is more than the return on the stock with 19.67%. We would convert the debentures next year and resell the investment for a better return of 21%.

c) if Nata skips the dividend, the blowback ratio will improve to 100% this will improve the return on equity and higher expected share price of P2.