Explore BrainMass
Share

# Convertible Bonds, Warrants

This content was STOLEN from BrainMass.com - View the original, and get the already-completed solution here!

1)  Laser Electronics Company has \$30 million in 8 percent convertible bonds outstanding. The conversion ratio is 50; the stock price is \$17; and the bond matures in 15 years. The bonds are currently selling at a conversion premium of \$60 over their conversion value. If the price of the common stock rises to \$23 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 \$60 to \$10.

2) Assume you can buy a warrant for \$5 that gives you the option to buy one share of common stock at \$14 per share. The stock is currently selling at \$16 per share.

a. What is the intrinsic value of the warrant?

b. What is the speculative premium on the warrant?
c. If the stock rises to \$24 per share and the warrant sells at its theoretical value without a premium, what will be the percentage increase in the stock price and the warrant price if you bought the stock and the warrant at the prices stated above? Explain this relationship.

See attached file for full problem description.

#### Solution Preview

12)
Conversion Value -- The value of the convertible security in terms of the common stock into which the security can be converted. It is equal to the conversion ratio times the current market price per share of the common stock.
Premium Over Conversion Value -- The market price of a convertible security minus its conversion value; also called conversion premium.

Price at which the bond is purchased
Conversion ratio = Number of ...

#### Solution Summary

Answers questions on Convertible Bonds, Warrants.
1) calculates the rate of return on investment in convertible bonds.
2) calculates the intrinsic value and the speculative premium on the warrant.

\$2.19

## Capital Decisions: Equity, Convertible Bonds, Warrants

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 percent 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 percent coupon, convertible into 100 shares of common stock for each \$1,000 bond (that is, the conversion price is \$10 per share).
Alternative 3: Sell debentures at an 8 percent coupon, each \$1,000 bond carrying 100 warrants to buy common stock at \$10.

John L. Howland, the president, owns 80 percent 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:

> Balance Sheet

Total assets \$550,000

Current Liabilities \$400,000
Common stock par \$1 \$100,000
Retained earnings \$50,000
Total claims \$550,000

> Income Statement

Sales \$1,100,000
All costs except interest \$990,000
EBIT \$110,000
Interest \$20,000
EBT \$90,000
Taxes \$36,000
Net Income \$54,000

Shares outstanding 100,000
Earnings per share \$0.54
Price/earnings ratio 15.83x
Market price of stock \$8.55

> Questions:

a. Show the new balance sheet under each alternative. For those Alternatives 2 and 3, show the balance sheet after conversion of the bonds or 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. Holand's control position under each alternative, assuming that he does not purchase additional 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 percent of total assets?
d. What will be the debt ratio under each alternative?
e. Which of the three alternatives would you recommend to Howland, and why?

View Full Posting Details