Managerial Finance

Mini Case 4

  1. Describe briefly the legal rights and privileges of common stockholders. 

Stockholders/owners have the following rights and privileges

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  • The preemptive right. This right allows them to purchase additional shares on offer by the firm. 
  • Being the owners, they have an automatic right to control. They do this through electing the company’s directors who are tasked with managing the firm while being answerable to the owners.
  1. (1) Write out a formula that can be used to value any stock, regardless of its dividend pattern.

=

(2) What is a constant growth stock?  How are constant growth stocks valued?

A constant growth stock is a stock whose dividends are expected to grow at a constant rate in the foreseeable future. As such, a specified number, for instance, 10% growth in dividends, is used as a best estimate of growth. To value constant growth stocks in the first year, we use the following formula to determine the dividends

D1 = D0(1 + g), D2 = D1(1 + g) = D0(1 + g)2, and so on depending on the year we are interested in, 

Using the dividends obtained there above, we are able to determine the value of the stock using the following Gordon’s model; 

= = .

Where; D1 is next expected dividend

rs is required rate of return of stock

g is the constant growth rate

(3) What happens if a company has a constant g which exceeds its rs?  Will many stocks have expected g > rs in the short run (i.e., for the next few years)?  In the long run (i.e., forever)?

Mathematically, the Gordon’s model requires that rs > g. In the event that the g is greater than rs, the model gives a negative stock price which is untenable. The model is therefore not appropriate for unless; 

  1. rs > g
  2. g is reasonably expected to continue indefinitely
  3. g is a constant

In the long-run, supernormal growth where gs > rs cannot be sustained indefinitely.

  1. Assume that temp force has a beta coefficient of 1.2, that the risk-free rate (the yield on T-bonds) is 7 percent, and that the market risk premium is 5 percent.  What is the required rate of return on the firm’s stock?

Using SML

rs = rRF + (rM – rRF)bTemp Force 

                  = 7% + (12% – 7%)(1.2)

      = 7% + (5%)(1.2) 

      = 7% + 6% 

= 13%.

  1. Assume that Temp Force is a constant growth company whose last dividend (D0, which was paid yesterday) was $2.00, and whose dividend is expected to grow indefinitely at a 6 percent rate.
  2. What is the firm’s expected dividend stream over the next 3 years?

Expressed in a timeline, Temp’s Force constant growth stock will have dividends as follows; 

   0                        1                        2                         3                       

   |            |            |            |           

D0 = 2.00              2.12                   2.247                 2.382

     1.88

     1.76

     1.65

  1. What is the firm’s current intrinsic stock price?

Using the constant growth model:

=

=

=

= $30.29.

  1. What is the stock’s expected value one year from now?

After one year, we should consider the dividend for the second year, as such,

=  

=  

=  

= $32.10.

  1. What are the expected dividend yield, the capital gains yield, and the total return during the first year?

The expected dividend yield is given by

Dividend Yield = ,

Dividend yield = $2.12/$30.29             

             = 7.0%

While the expected capital gains yield is derived as 

Capital Gains Yield = = r – .

Capital gains yield = 13%-($2.12/$30.29)=6.0%

Total Return is obtained from the addition of Dividend Yield to Capital Gains Yield =7%+6%=13%

Ethical Issues

Companies need to maintain a delicate balance between the investor needs and societal needs. As such, the need to integrity and trust is unrelenting. Integrity calls for conducting of business in an honest and fair method. With integrity comes trust from other business partners, most importantly the customers. Fairness entails treating every party in the business fairly. Development of an environment that pays attention to professional ethics, especially when it comes to employee relations and rights is the beginning of ethics. Being unbiased when treating employees cultivates an environment of trust. 

In marketing, customers expect to have products and services that will assure them of their value for money. This means that promotional messages must not promise what the business cannot deliver. Marketing must exhibit transparency, trustworthiness, and responsibility. In so doing, integrity and fairness to consumers as well as other stakeholders is assured. 

In the presentation of financial reports, ethics come a long way to assure that there is significant openness and presentation of material facts. Hoodwinking investors with inflated share prices is unethical and short-lived as it can be remembered in the case of Enron. Financial figures and statements must reflect the true and fair position. If compromised for whatever reasons, it becomes unethical. 

Diversity in the workplace is something that tests ethics in a company. The recruitment of a workforce that is reflective of the societal composition in such a way that the interests of members of the society are preserved is critical to the success of a company. as such, there will be respect and overall pooling of resources, material and intellectual to safeguard the interests of the company. 

Mini Case 3 

  1. What are the key features of a bond?

A bond has the following features, 

  • Par value which is the face value of a bond and is paid at maturity. It is often assumed to be $1,000
  • Coupon interest rate which is the stated interest rate and is generally fixed. 
  • Maturity is the period (years) until the bond matures and at that point it is repaid
  • Issue date is the date when the bond was issued
  • Default risk is the risk that an issuer of the bond will not make required payments upon maturity 
  1. What are call provisions and sinking fund provisions?  Do these provisions make bonds more or less risky?

A call provision allows the issuer of bonds to redeem such bonds at a specified time before the stipulated maturity date. It is often done to take advantage of falling interest rates, as such, when interest rates fall, it the issuer calls the bonds and issues new bonds at a lower rate. With this in mind, borrowers pay more on callable bonds.  

In a sinking fund provision, the issuer retires the loan over and during its life rather than waiting till the maturity date to make a single payment. It reduces the risk exposure to the investor and further shortens the maturity period. For investors, it reduces their earnings especially if rates fall after issuance. 

  1. How is the value of any asset whose value is based on expected future cash flows determined?

To determine the present value of an asset, the expected future cash flows are used. The following formula is used; 

  1. How is the value of a bond determined?  What is the value of a 10-year, $1,000 par value bond with a 10 percent annual coupon if its required rate of return is 10 percent?

The value of a bond is determined by considering interest rates and coupon payments which are the cash flows. It is arrived at by adding the present value of the maturity lump sum payment and the interest values which are paid continuously per year for the entire period. 

In this case, we use the formula, 

VB = $100(PVIFA10%,10) + $1,000(PVIF10%,10)

      = $100 ((1-1/ (1+.1)10)/0.10) + $1,000 (1/ (1+0.10)10).

      =385.54+614.46

      =$1,000

  1. (1)  What would be the value of the bond described in part d if, just after it had been issued, the expected inflation rate rose by 3 percentage points, causing investors to require a 13 percent return?  Would we now have a discount or a premium bond?

Using the formula

VB(10-YR) = $100(PVIFA13%,10) + $1,000(PVIF13%,10) we substitute

       = $100 ((1-  1/(1+0.13)10)/0.13) + $1,000 (1/(1+0.13)10)

       = $542.62 + $294.59 

          = $837.21.

In this situation, it can be observed that the required rate of return, r, is higher than the coupon rate. As such, the bond falls below par. As such, sell at a discount.  

(2) What would happen to the bonds’ value if inflation fell, and rd declined to 7 percent?  Would we now have a premium or a discount bond?

If inflation hits, then the following formula is applied; 

VB(10-YR) = $100(PVIFA7%,10) + $1,000(PVIF7%,10), thus

        = $100 ((1-  1/(1+0.07)10)/0.07) + $1,000 (1/(1+0.07)10)

               = $702.36 + $508.35 

        = $1,210.71.

In this situation, the bond value rises above par. as such, sell at a premium. 

(3) What would happen to the value of the 10-year bond over time if the required rate of return remained at 13 percent, or if it remained at 7 percent?  (Hint:  with a financial calculator, enter PMT, I, FV, and N, and then change (override) n to see what happens to the PV as the bond approaches maturity.)

The value of a bond at maturity must be equal to the par value. If interest rates remain constant at 13%, the value of a discount bond increases with an approaching maturity date. If the rate is constant at 7%, the value of the bond decreases to $1,000 with an approaching maturity date. This is demonstrated in the graph below

  1. (1) What is the yield to maturity on a 10-year, 9 percent annual coupon, $1,000 par value bond that sells for $887.00? That sells for $1,134.20? What does the fact that a bond sells at a discount or at a premium tell you about the relationship between rd and the bond’s coupon rate?

It has been provided that; n = 10, PV = -887, pmt = 90, and FV = 1000

(90+((1000-1134.20)/10)/((1000+1134.20)/2) 

= 7.18%

For the same bond, the coupon payment is 1000(0.09) = 90 and thus, the Yield to Maturity at $887 = (90 + ((1000 – 887)/10)/(1000 + 887)/2    

   = 10.73%

A bond that sells at a premium sell higher than the par value indicating that the interest rate is lower than the coupon rate. On the other hand, a discount bond sells at a higer interest rate than the coupon rate. 

(2) What are the total return, the current yield, and the capital gains yield for the discount bond?  (Assume the bond is held to maturity and the company does not default on the bond.)

=0.1015

=10.15%

Capital Gains Yield =

                            = ($893.87 – $887)/$887 

        = 0.0077 

        = 0.77%,

= 10.15%+0.77%

=10.92%

Mini Case 6

  1. Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the weighted average cost of capital and free cash flows. 

How capital structure impacts on value is dependent on the effect of debt on WACC and Free Cash Flow. 

Creditors have a prior claim on the cash flows as compared to stockholders. As such, the fixed claim of debt holders raises the risk of stockholders’ residual claim. This drives the cost of stock up. 

Debt causes undesirable effects to a company, the most notable being increasing the exposure of a business to bankruptcy. The pre-tax cost of debt also increases with debt. 

Piling on debt increases the percentage of the firm financed by low-cost debt while at the same time decreasing the percentage of the firm financed using high-cost equity. Debt impacts on the morale of managers thus reducing their abilities to focus on the need to implement policies that improve cash flow. 

Interest expenses are deductible effectively reducing the tax burden. Consequently, cash available to investors is increased. 

When all the above mentioned factors are combined, their effect on WACC is uncertain since some of the factors move in opposite directions. 

  1. (1) What is business risk?  What factors influence a firm’s business risk?

Business risk is the possibility of a company earning less than projected profits (EBIT). Business risk is influenced by factors such as uncertain demand, prices, costs, and liabilities. Competition and government regulations also affect business risk. 

(2) What is operating leverage, and how does it affect a firm’s business risk?  Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variables costs of $10.

Operating leverage is the degree/level at which a company can increase operating income (EBIT) by increasing revenue (quantity sold). With a higher operating leverage, a business faces more business risk. This is because a small change in sales revenues, leads to a large decline in operating income. 

F=$200, P=$15, AND V=$10:

QBE = F / (P – V)

QBE = $200 / ($15 – $10) 

  = 40

Recommendations on Financial Decisions

Assessing a company’s debt absorption capabilities against its current earnings and capitalization is key to determining how to gear a company. PizzaPlace has an EBIT of 50 million and 10 million outstanding shares. From my assessment, the company can absorb more debt to raise more capital. Debt can be raised using short-term or long-term strategies. If the debt financing in the company is raised to 50%, the cost of debt raises to12%. With a 20% debt capital financing, the company incurs a cost of debt of 8%. These two extremes differ only by 4% in costs. As such, the company can make significant investments with the 50% debt and increase its ability to generate and positively impact EBIT while loading its debt by a 4% addition cost. 

Considering the free risk rate of 6%, it means that investors or creditors to the company might not be particularly interested in lending or investing in the company if its debt ratio is 20%. When the debt is raised to 50%, investors are left with 6% more reward above the risk free rate (equity risk premium). As such, the investment is attractive to investors. As such, I would advise the company to engage investors or creditors with the intention to incur either long-term or short-term debt. As a precaution, the debt should be procured after developing a significant and plausible absorption and implementation plan. Failure to have this plan before getting the debt puts the business on a path with pitfalls which might further compromise the business situation especially if the debt does not generate sufficient income using the debt. 

Mini Case 5

  1. (1) What is meant by the term “distribution policy”? How have dividend payouts versus stock repurchases changed over time?

A distribution policy is a firm’s policy with regards to level of distributions and the form of distributions, and lastly, the stability of such distributions. It is the manner in which a company decides to pay its investors using profits generated. Form of distributions include aspects such as dividends or stock repurchases. 

Stock repurchases have increased while dividend payout rates have continued to decline. At the same time, the percent of total payouts to net income has remained relatively stable. Young companies start out by making distributions and the policy change as they mature and gain the trust of investors. 

(2) The terms “irrelevance,” “bird-in-the-hand,” and “tax effect” have been used to describe three major theories regarding the way dividend payouts affect a firm’s value.  Explain what these terms mean, and briefly describe each theory.

Dividend irrelevance is a theory that explains the indifference experienced by investors with regards to dividends and capital gains. As such, the inability to decide between the two by investors renders the dividend policy irrelevant with regards to the effect of the dividend policy to the value of the firm. MM while developing the theory assumed that there are no taxes, floatation costs, or transaction costs. 

Bird-in-the-hand refers to the theory that a dollar handed to investors by a company as dividends is preferred to a dollar retained in the business. Myron Gordon and John Lintner perceived that investors prefer high payouts to mitigate agency costs and also depriving managers excess cash which would be wasted due to lack of prudence. Investors perceive a dollar retained by the firm with the promise to produce more dollars in the future as risky. As such, the dividend policy affects the firm’s value. 

The tax effect theory asserts that investors might prefer a low payout to a high payout due to the tax effect due to the following; first, taxes are not paid on capital gains until a time when the stocks are sold. Second, when one holds capital gains stock till death, capital tax is not applicable. Beneficiaries who are recipients of the stock can redeem the stock’s value on the day of death as their costs basis and consequently escape capital gains tax. 

(3) What do the three theories indicate regarding the actions management should take with respect to dividend payout?

As explained above, when held as the correct theory, the dividend irrelevance theory invalidates dividend payouts. If the bird-in-hand is the correct theory, then if follows that a firm should pay the highest dividends to attract more investors and raise its stock price/value. Of the tax effectr theory holds, then a firm should aim at having the low payouts to minimize tax effect and maximize stock price. The three theories conflict each other. 

(4) What results have empirical studies of the dividend theories produced? How does all this affect what we can tell managers about dividend payouts?

Empirical studies, just like the theories, produce mixed results. Different firms use different distribution policies and responses. As such, some studies have confirmed that firms with high dividend payout have high stock values. Other studies have demonstrated that firms with high payouts especially in low investor protection countries, have less value, a phenomenon synonymous with the dividend preference theory. 

  1. Discuss (1) the information content, or signaling, hypothesis, (2) the clientele effect, and (3) their effects on distribution policy.

When dividends are announced, different stakeholders get different signals about future earnings. Investors perceive dividend increases as signals of management appreciation of the future. Managers are not fond of cutting dividends unless they have sufficient reasons to believe that such dividends are not sustainable in the future. Investors might interpret a dividend increase as either as management approval of the sustainability of EPS (signaling hypothesis) or a preference for high dividend stock (bird-in-hand theory). As such, when management gives larger than normal dividends, investors interpret it as a sign that the future will be brighter and stock prices increase. The opposite is true while a normal increase is neutral. 

Different groups of investors/clients, have different preferences for dividend policies. Investors who are aged prefer investments offering high dividend stocks since they want the dividends to be their source of current income. Investors in earning years prefer dividend policies where capital gains are reinvested and have low appetite for current income hence prefer low dividend stocks. Dividend policy must reflect the majority of the clientele and when it upsets them, the stock price is negatively affected. Managers must act to adopt a distribution policy that is in tandem to the majority of the clientele. 

Mini Case 7

  1. What agencies regulate securities markets?

The main state agency that regulates securities markets in the U.S. is the Securities and Exchange Commission. Its responsibilities include the regulation of all the national stock exchanges. With this in mind, it is the role of all companies listed in the on the securities exchange to abide by the commissions reporting guidelines as well as file annual report in a manner prescribed. SEC prohibits manipulation by pools, insider trading, and controlling over proxy statement and soliciting of votes. 

The Federal Reserve Board through the use of margin requirements, control the flow of credit into security transactions. Individual states also exercise some control especially over the issuance and operationalization of securities within their jurisdictions. Due to the intricate nature of the securities market, the different agencies work together to ensure that there is stability, credibility, and integrity of the system.

  1.  How are start-up firms usually financed?

Start-ups’ first line of financing comes from the founders. After demonstrating a viable project/idea, the first line of external financing comes from angel investors who are wealthy individuals. As the start-up progresses, venture capital funds find their way to the start-up followed by institutional investors. Managers from institutional investors often prefer to sit in the company’s boards. 

Mini Case 8

  1. How does preferred stock differ from both common equity and debt?  Is preferred stock more risky than common stock?  What is floating rate preferred stock?

Preferred stock can be descried as a hybrid since it contains some features that mimic debt and others common equity. Just like debt, preferred payments are fixed and are preferentially treated A company cannot pay dividends on common equity without having paid preferred stock. Preferred dividends are cumulative and if omitted, they are paid first before common stock. When it comes to controlling of a company, preferred stock holders elect directors especially if preferred dividends are omitted for the same period. With these facts in mind, it can be authoritatively said that preferred stock lies between debt and common stock as it possess characteristics of both in the risk spectrum. Floating rate preferred stock in most cases trades at par as it has a dividend rate indexed similarly to government/treasury securities. 

  1. How can knowledge of call options help a financial manager to better understand warrants and convertibles?

A call option to begin with is a contract giving the holder the right, but not an obligation, to purchase a defined asset such as stock, within a specified period and at a specific price. A warrant is a long term option while a convertible has in its structure a call option. Understanding the valuation of call options on the part of financial managers is critical in making decisions with regards to how warrant and convertibles should be done. 

  1. (1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000?

If the total package is sold for $1,000, it follows that, 

Vpackage = Vbond + Vwarrants = $1,000, 

But 27 warrants have an estimated value of $5 each, therefore, 

Vwarrants = 27($5) = $135.

Remember, Vpackage = Vbond + Vwarrants = $1,000, 

Thus, Vbond + $135 = $1,000 

             Vbond = $865; the coupon rate should lead to the bond selling for $865. 

Given that N = 20, I = 10, PV = -865, and FV = 1,000, using a financial calculator to find PMT, we get PMT=84.14 ≈ $84, therefore, the required coupon rate is given by $84/$1,000 = 8.4%. 

(2) When would you expect the warrants to be exercised?  What is a stepped-up-exercise price?

A warrant will sell at a premium above its expiration value in the open market when the warrant is exercised. As such, just before the expiration of the premium, an investor with a preference for cash should sell his/her warrants in the market rather than exercise them. But some warrants contain step-up provisions. 

A stepped-up exercise price is essentially a provision in a warrant that raises the exercise price over time. Here, the exercise price of stepping up increases. With an increase in price, the warrant loses value since it is no longer attractive. A step up provision therefore encourages holders of warrants to exercise just before step-up.  

(3) Will the warrants bring in additional capital when exercised? If EduSoft issues 100,000 bond-with-warrant packages, how much cash will EduSoft receive when the warrants are exercised? How many shares of stock will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding).

Given that;

Number of warrants/bond = 27

Number of bonds = 100,000

Strike price = $25, then, 

Cash = (Number of warrants/bond) x (Number of bonds) x (Strike price)

Cash = 27 x 100,000 x $25

    = $67,500,000

Shares before the exercise, 20 million

New shares = Number of warrants/bond x Number of bonds

New shares = 27 x 0.1 million

New shares = 2.7 million

Shares at Year-10 = 20 + 2.7 

= 22.7 million

(4) Because the presence of warrants causes a lower coupon rate on the accompanying debt issue, shouldn’t all debt be issued with warrants? To answer this, estimate the expected stock price in 10 years when the warrants are expected to be exercised, then estimate the return to the holders of the bond-with- warrants packages. Use the corporate valuation model to estimate the expected stock price in 10 years. Assume that EduSoft’s current value of operations is $500 million and it is expected to grow at 8% per year.

The cost of debt: rd = 10%.

The value of operations Vop,0 = $500 million is expected to grow at a rate of 8% per year.

Vop,10 = Vop,0 (1+g)10

Vop,10 = $500 (1+0.08)10 

Vop,10 = $1,079.46 m

For each bond: N = 10; I/YR = 10; PMT = 84; FV = 1000. Solve for PV = −$901.6869. The total value of debt is: 

Debt = (# of bonds) x (Price per bond)

Debt = (0.1 million) x ($901.6869)

Debt = $90.169 million

Value of operations$1,079.46 
Add Value of cash received at exercise$67.50 
Total intrinsic value of firm$1,146.96 
Less Debt$90.17 
Intrinsic value of equity$1,056.79 

But, Intrinsic Price per Share= Intrinsic value of equity/Number of Shares 

                                               = $1,056.79/$22.7

=$46.55

Payoff at the time of exercise is calculated as follows; 

For each warrant:

Add $46.55 for value of each share

Less $25.00 paid to exercise warrant

Add 21.55 net payoff per warrant

For each bond:

Payoff = Payoff/warrant x Warrants/Bond

Payoff = $21.55 x 27

Payoff = $581.85

Estimating the return to holders; 

Consider; amount paid for initial value, and amount received after exercise. 

But we have , N = 10; PV = −135; PMT = 0; FV = $581.85, 

Using a financial calculator to solve for rw, we get rw=15.73%, then, 

Combine expected return on the bonds and warrants as follows; 

rBwW = (% straight debt) x(rd) + (% warrants) x(rw)

rBwW = ($865/$1,000) x 10%) + (($135/$1,000) x15.73%)

rBwW = 10.77%

(5) How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock (which is 13.4%)?

The cost of bonds is higher than 10% cost of straight debt. This is because an investor perceives bonds as riskier than straight debt. On the other hand, it is lower than the cost of equity since its risk factor is less than that of equity. 

(6) If the corporate tax rate is 40%, what is the after-tax cost of the bond with warrants?

The bond was issued at  a discount ($865 instead of $1,000). As such, after-tax cost of debt cannot be rd(1-T), thus, it is necessary to find the rate of return given after-tax coupon. 

Given that N = 20, PMT = $84(1-0.4) = $50.4, PV = -$865, FV = $1,000; solve for I/YR using the financial calculator to get rd = 6.24%.

Since there exists no tax implication to warrant exercise

After Tax rBwW = ($865/$1,000) x 6.24% + ($135/$1,000) x 15.73%

After Tax rBwW = 7.52%

  1. (1) What conversion price is built into the bond?

Conversion Price = PC =

=$1,000/40

=$25

    (2) What is the convertible’s straight-debt value?  What is the implied value of the convertibility feature?

Required rate of return on a 20-year straight bond is 10%,  

Therefore, V = $85(PVIFA10%,20) + $1,000(PVIF10%,20

            = $872.30.

(3) What is the formula for the bond’s expected conversion value in any year?  What is its conversion value at year 0?  At year 10?

The value of converting at any year is CR(Pt), where,

Pt = P0(1 + g)t

And CR (Conversion Ratio) is the number of shares received

As such; CVt = CR(Pt)

= CR(P0)(1 + g)t

= 40($20)(1.08)t

Hence, for Year 0 and Year10 we have

Year 0:  CV0 = 40($20) (1.08)0 = $800.

Year 10:  CV10 = 40($20) (1.08)10 = $1,727.14.

(4) What is meant by the “floor value” of a convertible?  What is the convertible’s expected floor value at year 0?  At year 10?

The floor value is the straight-debt value and the conversion value. As it has been determined, the straight-debt at Year 0 is $872.30. In the same year, the conversion value is $800. As such, the floor value is $872.30. At Year 10, the conversion value is $1,727 which makes it higher than the straight-debt value making it the floor price for the same year. The convertibility sells above the floor value since convertibility includes additional value. 

(5) Assume that Edusoft intends to force conversion by calling the bond as soon as possible after its conversion value exceeds 20 percent above its par value, or 1.2($1,000) = $1,200.  When is the issue expected to be called?  (Hint:  recall that the call must be made on an anniversary date of the issue.)

Conversion value starts at $800and it grows at the rate of 8% per year and aims at $1,200. Using the financial calculator with I = 8, PV = -800, and FV = 1200 to find n, we find that n=5.27. Since the call must be at an anniversary date, then the call is pushed to the next full year which is Year 6. 

(6) What is the expected cost of capital for the convertible to Edusoft? Does this cost appear to be consistent with the riskiness of the issue?

The firm would receive $1,000 now, and make consistent coupons for 6 years. At the end of the sixth year, the firm would pay back the stock worth $1,269.50=40($20) (1.08)6 in addition to $85 coupon. As such, at the end of the sixth year there firm will pay $1,354.50 =$1,269.50+$85

The cost of capital is calculated as follows, 

rs = + g

= ($1,000(1.08)/$20) +8%

= 13.4%

The cost of straight debt is 10%, and that of equity as determined above is 13.4%. IRR of the cash flow stream is 11.84% and thus reasonable as it falls between cost of straight debt and cost of equity. 

(7) What is the after-tax cost of the convertible bond?

Given the following variables and using a financial calculator, rc, the after-tax cost of the convertible bond is determined to be 8.71%. 

n= Number of years until conversion =6
PV = Initial cost of bond =($1,000.00)
PMT = coupon payment =$51.00 
FV = Conversion value =$1,269.50 
RATE = rc =8.71%
  1. Mr Duncan believes that the costs of both the bond with warrants and the convertible bond are close enough to one another to call them even, and also consistent with the risks involved.  Thus, he will make his decision based on other factors.  What are some of the factors which he should consider?

Mr. Duncan needs to have a serious consideration of whether he the company is able and willing to commit to a debt spanning 20 years. With the confort of the possibility of conducting conversion, the debt can be redeemed, however, if the share price of the company rises, exercising the debts (convertibles and warranties) will get difficult and the debt will remain.

The other factor is the future needs for additional capital. If the company foresees a situation where it will need capital in the future, it will therefore be wise to consider warrants because during their exercise, additional capital is realized without eliciting the need to do away with the accompanying low coupon debt issue. The convertible does not fit this bill during conversion. 

  1. How do convertible bonds help reduce agency costs? 

Agency costs occur due to the conflict existing between shareholders and bondholders. In instances where a firm issues low cost straight debt and invests in rather risky avenues, bondholders get suspicious and charge high interest rates on their debt. With convertible bonds, it is possible to share in the inverted potential to reduce the rate and consequently the agency costs

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