Question
In: Finance
Vernon Glass Company has $20 million in 10 percent convertible bonds outstanding. The conversion ratio is...
Vernon Glass Company has $20 million in 10 percent convertible bonds outstanding. The conversion ratio is 45, the stock price is $16, and the bond matures in 20 years. The bonds are currently selling at a conversion premium of $45 over their conversion value. If the price of the common stock rises to $22 on this date next year, what would your rate of return be if you bought a convertible bond today and sold it in one year? Assume on this date next year, the conversion premium has shrunk from $45 to $15.
Solutions
Expert Solution
We first need to determine the value of the convertible
bond.
Conversion value=Conversion ratio*Stock price=45*$16=$720
Where, conversion ratio is 45 and stock price is $16
Market price of the bond=Conversion value+Conversion premium
Conversion value=$720
Conversion premium=$45
Market price of the bond=$720+$45=$765
Given that, the price of the common stock rises to $22 on this
date next year.
Conversion ratio=40
Now, on this date next year the convertible bond's price will
be:
Stock price on this date next year*Conversion ratio
=$22*40=$880
Assuming that on this date next year, conversion premium has
shrunk from $45 to $15 as given in the question, we get the market
value of the bond as:
Convertible bond's price on this date next year+ New premium after
it has shrunk from $45 to $15=$880+$15=$895
Rate of return=(Final value-Initial value)/Initial value=($895-$765)/$765=$130/$765=0.169934641 or 16.99%
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