Question

Peter Krone is the chief financial officer (CFO) of Echo Inc. The firm was founded seven years ago to provide educational services for the rapidly expanding primary and secondary school markets. Although Echo Inc. has done well, the firm's founder believes that an industry shakeout is imminent. To survive, Echo Inc. must grab market share now, and this will require a large infusion of new capital. Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Krone does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, the interest payments on a new debt issue would be prohibitive. Thus, he has chosen to finance the needed capital using bonds with warrants. Mr. Krone estimates that Echo Inc. could issue a bond-with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a strike price of $25 and 10 years until expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%.

1- what coupon rate should be set on the bond with warrants if the total package is to sell for $1,000 ?

2-if Echo inc. issues 100,000 bond with warrant packages how much cash will Echo Inc receive when the warrants are exercised ?

3- how much shares of stock will be outstanding after the warrants are exercised ? ( Echo Inc. currently has 20 million shares outstanding )

Answer 1

Given:

Bonds with warrants package consists of a 20-year bond and 27 warrants

Strike price of warrant = $25

Expiration = 10 years

Value of warrant when traded separately = $5

Coupon on similar bond without warrants = 10%

1. Coupon rate to be set on the bond with warrants:

Value of package = Value of bond + Value of warrants

Value of package = Value of bond + (no. of warrants * Value of warrant when traded separately)

   1000                   = Value of bond + (27 * 5)

1000                    = Value of bond + $135

Therefore, value of bond = 1000 – 135 = $865

Now, we need to find out the payment for this bond.

We know that,

I/Y (required return) = 10%

N (yield to maturity) = 20 years

PV = $865

FV = $1000

You can use either the excel or finance calculator to find the payment.

I have used excel to find the payment for this bond. I have attached a screenshot with this solution where you can find the excel formula to calculate a payment.

Payment = $84.14 (calculated in excel)

Coupon rate to be set on bond with warrants = payment / Par value

                                                                                          = 84.14 / 1000

                                                                                         = 0.08414 = 8.41%

1. Amount of cash will be received by Echo inc. if it issues 100,000 bonds:

Each bond contains 27 warrants

Each warrant has a strike price of $25

No. of bonds going to be iuused = 100,000

Cash that will be received by Echo inc. = 100,000 * 27 * 25

                                                                        = 67.5 million

1. Shares of stock will be outstanding after the warrants are exercised:

Echo inc. currently has 20 million shares outstanding

Now they have issued additional 100,000 bonds

Total no of additional warrants issued = 27 * 100,000

                                                                           = 2,700,000

                                                                           = 2.7 million

No. of shares will be outstanding after the warrants are exercised = 20 million + 2.7 million

                                                                                                                                = 22.7 million