Question

Roberts Manufacturing needs to raise $5,000,000. The firm can raise the money by either selling convertible bonds or stock purchase warrants. The convertible bonds will have 20 years to maturity, a 5 percent annual coupon rate and conversion ratio of 25 shares. The stock purchase warrants will have a 20 year maturity, a 6.5 percent annual coupon rate, and have 1 warrant attached to each bond that can be converted into 4 shares of common stock for $40 per share. The firm is in the 20 percent marginal tax rate and has operating profits equal to 20 percent of the total capitalization.

The current total capitalization is: Debenture = $0; Common Stock ($5 par) = $15,000,000; Additional Paid in Capital = $15,000,000; and Retained Earnings = $10,000,000 Total capitalization = $40,000,000

Part a: Find the total capitalization for the convertible bond both after the financing has been acquired and after the conversion of the bond. (Show your work)

Part b: Find the EPS for the convertible bond both after the financing has been acquired and after the conversion of the bond. (Show your work)

Answer 1

Part a: Find the total capitalization for the convertible bond both after the financing has been acquired and after the conversion of the bond. (Show your work)

The total capitalization for the convertible bond will remain the same in either case and will be = total capitalization before + new funds raised = $ 40,000,000 + 5,000,000 = $ 45,000,000

Part b: Find the EPS for the convertible bond both after the financing has been acquired and after the conversion of the bond. (Show your work)

After the financing has been acquired:

Operating profit = EBIT = 20% of current capitalization = 20% x 40,000,000 = 8,000,000

Interest = anual coupon rate x debt = 5% x 5,000,000 = 250,000

Net income = (EBIT - Interest) x (1 - tax rate) = (8,000,000 - 250,000) x (1 - 20%) = 6,200,000

Number of shares outstanding = N = COmmon stock value / par value = 15,000,000 / 5 = 3,000,000

Hence, EPS = Net in come / N = 6,200,000 / 3,000,000 = $ 2.07

after the conversion of the bond:

Operating profit = EBIT = 8,000,000

Interest = 0 as bonds have been converted now

Net income = (EBIT - Interest) x (1 - tax rate) = (8,000,000 - 0) x (1 - 20%) = 6,400,000

Number of shares outstanding = N1 = N + conversion ratio x no. of convertible bonds = 3,000,000 + 25 x 5,000,000 / 1,000 = 3,125,000

Hence, EPS = Net in come / N1 = 6,400,000 / 3,125,000 = $ 2.05