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Financial Management: Theory and Practice

Eugene F. Brigham, Michael C. Ehrhardt

Chapter 21

Hybrid Financing: Preferred Stock, Warrants, and Convertibles - all with Video Answers

Educators

Chapter Questions

03:11

Problem 1

Gregg Company recently issued two types of bonds. The first issue consisted of 20-year straight debt with an $8 \%$ annual coupon. The second issue consisted of 20-year bonds with a $6 \%$ annual coupon and attached warrants. Both issues sold at their $\$ 1,000$ par values. What is the implied value of the warrants attached to each bond?

Nick Johnson
Nick Johnson
Numerade Educator
02:32

Problem 2

Peterson Securities recently issued convertible bonds with a $\$ 1,000$ par value. The bonds have a conversion price of $\$ 40$ a share. What is the convertible issue's conversion ratio?

Kaylee Mcclellan
Kaylee Mcclellan
Numerade Educator
06:21

Problem 3

Maese Industries Inc. has warrants outstanding that permit the chase 1 share of stock per warrant at a price of $\$ 25$
a. Calculate the exercise value of the firm's warrants if the common sells at each of the following prices: (1) $\$ 20,(2) \$ 25,(3) \$ 30,(4) \$ 100 .$ (Hint: A warrant's exercise value is the difference between the stock price and the purchase price specified by the warrant if the warrant were to be exercised.)
b. At what approximate price do you think the warrants would actually sell under each condition indicated above? What time value (price minus exercise value) is implied in your price? Your answer is a guess, but your prices and time values should bear reasonable relationships to one another
c. How would each of the following factors affect your estimates of the warrants' prices and time values in part b?
(1) The life of the warrant
(2) Expected variability $\left(\sigma_{\mathrm{p}}\right)$ in the stock's price
(3) The expected growth rate in the stock's EPS
(4) The company announces a change in dividend policy: whereas it formerly paid no dividends, hencefurth it will pay out all earnings as dividends.
d. Assume the firm's stock now sells for $\$ 20$ per share. The company wants to sell sume 20 -year, annual interest, $\$ 1,000$ par value bunds. Each bond will have attached 50 warrants, each exercisable into 1 share of stock at an exercise price of $\$ 25 .$ The firm's straight bonds yield $12 \% .$ Regardless of your answer to part b, assume that each warrant will have a market value of $\$ 3$ when the stock sells at $\$ 20 .$ What coupon interest rate, and dollar coupon, must the company set on the bonds with warrants if they are to clear the market?

Heather Duong
Heather Duong
Numerade Educator
02:39

Problem 4

The Tsetsekos Company was planning to finance an expansion. The principal executives of the company all agreed that an industrial company such as theirs should finance growth by means of common stock rather than by debt. However, they felt that the price of the company's common stock did not reflect its true worth, so they decided to sell a convertible security. They considered a convertible debenture but feared the burden of fixed interest charges if the common stock did not rise in price to make conversion attractive. They decided on an issue of convertible preferred stock, which would pay a dividend of $\$ 2.10$ per share.
The common stock was selling for $\$ 42$ a share at the time. Management projected earnings for 2006 at $\$ 3$ a share and expected a future growth rate of $10 \%$. It was agreed by the investment bankers and the management that the common stock would sell at 14 times earnings, the current price/earnings ratio.
a. The conversion ratio will be $1.0 ;$ that is, each share of convertible preferred can be converted into 1 share of common. Therefore, the convertible's par value (and also the issue price) will be equal to the conversion price, which, in turn, will be determined as a premium (i.e., the percentage by which the conversion price exceeds the stock price) over the current market price of the common stock. What will the conversion price be if it is set at a $10 \%$ premium? What will the conversion price be if it is set at a $30 \%$ premium?
b. Should the preferred stock include a call provision? Why?

Nick Johnson
Nick Johnson
Numerade Educator
01:33

Problem 5

Fifteen years ago, Roop Industries sold $\$ 400$ million of convertible bonds. The bonds had a 40 -year maturity, a $5.75 \%$ coupon rate, and paid interest annually. They were sold at their $\$ 1,000$ par value. The conversion price was set at $\$ 62.75$ the common stock price was $\$ 55$ per share. The bonds were subordinated debentures, and they were given an A rating; straight nonconvertible debentures of the same quality yielded about $8.75 \%$ at the time Roop's bonds were issued.
a. Calculate the premium on the bonds, that is, the percentage excess of the conversion price over the stock price at the time of issue.
b. What is Roop's annual before-tax interest savings on the convertible issue versus a straight-debt issue?
c. $\quad$ At the time the bonds were issued, what was the value per bond of the conversion feature?
d. Suppose the price of Roop's common stock fell from $\$ 55$ on the day the bonds were issued to $\$ 32.75$ now, 15 years after the issue date (also assume that the stock price never exceeded $\$ 62.75$ ). Assume interest rates remained constant. What is the current price of the straight bond portion of the convertible bond? What is the current value if a bondholder converts a bond? Do you think it is likely that the bonds will be converted?
e. The bunds uriginally suld for $\$ 1,000$. If interest rates on A-rated bonds had remained cunstant at $8.75 \%$ and the stock price had fallen to $\$ 32.75,$ what do you think would have happened to the price of the convertible bonds? (Assume no change in the standard deviation of stock returns.)
f. $\quad$ Now suppose the price of Roop's common stock had fallen from $\$ 55$ on the day the bonds were issued to $\$ 32.75$ at present, 15 years after the issue. Suppose also that the rate of interest had fallen from $8.75 \%$ to $5.75 \% .$ Under these conditions, what is the current price of the straight bond portion of the convertible bond? What is the current value if a bondholder converts a bond? What do you think would have happened to the price of the bonds?

Carson Merrill
Carson Merrill
Numerade Educator
05:32

Problem 6

The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $\$ 250,000$ carrying an $8 \%$ interest rate. Howland has been 30 to 60 days late in paying trade creditors.
Discussions with an investment banker have resulted in the decision to raise $\$ 500,000$ at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored):
. Alternative 1: Sell common stock at \$8.
, Alternative 2: Sell convertible bonds at an $8 \%$ coupon, convertible into 100 shares of common stock for each $\$ 1,000$ bond (that is, the conversion price is $\$ 10 \text { per share })$
, Alternative 3: Sell debentures at an $8 \%$ coupon, each $\$ 1,000$ bond carrying 100 warrants to buy common stock at $\$ 10.$
John L. Howland, the president, owns $80 \%$ of the common stock and wishes to maintain control of the company. One hundred thousand shares are outstanding. The following are extracts of Howland's latest financial statements:
a. Show the new balance sheet under each alternative. For Alternatives 2 and 3 show the balance sheet after conversion of the bonds ur exercise of the warrants. Assume that half of the funds raised will be used to pay off the bank loan and half to increase total assets.
b. Show Mr. I lowland's cuntrul pusition under each alternative, assuming that he does not purchase additiunal shares.
c. What is the effect on earnings per share of each alternative, if it is assumed that profits before interest and taxes will be $20 \%$ of total assets?
d. What will be the debt ratio (TL/TA) under each alternative?
e. Which of the three alternatives would you recommend to Howland, and why?

Heather Zimmers
Heather Zimmers
Numerade Educator
06:21

Problem 7

Niendorf Incorporated needs to raise $\$ 25$ million to construct production facilities for a new type of USB memory device. The firm's straight nonconvertible debentures currently yield $9 \% .$ Its stock sells for $\$ 23$ per share and has an expected constant growth rate of $6 \% .$ Investment bankers have tentatively proposed that the firm raise the $\$ 25$ million by issuing convertible debentures. These convertibles would have a $\$ 1,000$ par value, carry a coupon rate of $8 \%$ have a 20 -year maturity, and be convertible into 35 shares of stock. Coupon payments would be made annually. The bonds would be noncallable for 5 years, after which they would be callable at a price of $\$ 1,075 ;$ this call price would decline by $\$ 5$ per year in Year 6 and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Assume that management would call eligible bonds if the conversion value exceeded $20 \%$ of par value (not $20 \%$ of call price.
a. $A t$ what year do you expect the bonds will be forced into conversion with a call? What is the bond's value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because the conversion is immediately after the coupon is paid.)
b. What is the expected rate of return (i.e., before-tax component cost) on the proposed convertible issue?

Heather Duong
Heather Duong
Numerade Educator
06:21

Problem 8

Start with the partial model in the file FM12 Ch 21 P08 Build a Model.xls from the textbook's Web site. Using the data from Problem $21-7$, answer the following questions.
a. For each year, calculate (1) the anticipated stock price; (2) the anticipated conversion value; (3) the anticipated straight-bond price; and (4) the cash flow to the investor assuming conversion occurs. At what year do you expect the bonds will be forced into conversion with a call? What is the bond's value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because the conversion is immediately after the coupon is paid.)
b. What is the expected rate of return (i.e., before-tax component cost) on the proposed convertible issue?
c. Assume that the convertible bondholders require a $12 \%$ rate of return. If the coupun rate is set at $8 \%$, then what conversion ratio will give a bond price of $\$ 1,000 ?$ Given a conversion ratio of $35 \%,$ what coupun rate will give a bond price of $\$ 1,000 ?$

Heather Duong
Heather Duong
Numerade Educator