Purchase Solution

# Preferred Stock Valuation - Convertible Bonds

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1. Answer the questions given the following information concerning a convertible bond:

Principle: \$1,000
Coupon: 5%
Maturity: 15 years
Call price: \$1,050
Conversion Price: \$37 (i.e. 27 shares)
Market price of common stock: \$32
Market price of the bond: \$1,040

A. What is the current yield of this bond?
B. What is the value of the bond based on the market price of the common stock?
C. What is the value of the common stock based on the market price of the bond?
D. What is the premium in terms of stock that the investor pays when he or she purchased the convertible bond instead of stock?
E. Nonconvertible bonds are selling with a yield to maturity of 7%. If this bond lacked the conversion feature, what would the approximate price of the bond be?
F. What is the premium in terms of debt that the investor pays when he or she purchases the convertible bond instead of a nonconvertible bond?
G. If the price of the common stock should double, would the price of the convertible bond double? Briefly explain your answer.
H. If the price of the common stock should decline by 50%, would the price of the convertible bond decline by the same percentage? Briefly explain your answer.
I. what is the probability that the corporation will call this bond?
J. Why are investors willing to pay the premiums mentioned in parts (d) and (f)?

2. Dash Incorporated has the following convertible bond outstanding:

Coupon: 5%
Principle: \$1,000
Maturity: 12 years
Conversion Price: \$33.34
Conversion Ratio: 30 Shares
Call Price : \$1,000 + one year's interest

The bond's credit rating is BB, and comparable BB rated bonds yield 9%. The firm's stock is selling for \$25 and pays a dividend of \$0.50 a shares. The convertible bond is selling for \$1,000

A. What is the premium paid over the bond's value as debt? What justifies this premium?
B. Given the bond's income advantage, how long must the investor hold the bond to overcome the premium over the bond's value of the stock?
C. If the price of the stock were to decline by 50% what is the worst performance that the bond should experience and why?
D. If after 4 years the price of the stock has risen to \$40, what is the minimum percentage increase in the bond's price?
E. If the company pays a 20% stock dividend (i.e. not a cash dividend), what impact with that payment have on the price of the convertible bond?
F. If the bond is not converted, what does the investor receive when the bond matures? What is the annual return on the investment?
G. Is there any reason to expect that the firm will currently call the bond?
H. If the price doubles and if the bond is called and investors do not convert, what do they receive?

##### Solution Summary

The following posting helps with problems involving preferred stock valuation. Concepts covered include convertible bonds, yield of bonds, common stocks and bond credits.

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