Manjit Mittal, CFO, India Steel Industries Corp., is considering issuance of con

Question

Manjit Mittal, CFO, India Steel Industries Corp., is considering issuance of convertible bonds. The bonds will be of 30-year maturity and will have a coupon rate of 9.75 percent, par value of $1,000, and will be sold at a price of $1,075 (this is Vpackage from the lecture slides). The convertible bonds will have a 6-year call protection and the call price is $1,150. The conversion ratio is 25 on par value basis. The company’s stock is currently selling at $30 a share. The company paid a dividend of $2.00 last year and the dividends are expected to grow at a constant 6.0 percent rate into the foreseeable future. The company’s straight bonds have a 12.5 percent coupon rate. Assume semi-annual coupon payments in your computations.

(a) What is the convertible’s straight bond’s value? What is the implied value of the convertible feature?
(b) What will be the floor value of the bond at the end of year 7? Assume that straight bonds of comparable risk will have yield-to-maturity = 11.5 percent at that time (hint: this suggests what rd is at that time).
(c) Assuming full conversion of bonds into stock at the end of 8½ years. What will be the firm’s actual cost of capital for this issue of convertible bonds?
(d) Did the company gain or lose by issuing bonds with conversion feature, as opposed to issuing straight bonds? What motivated the investors to buy bonds at a lower coupon rate of 9.75% when bonds of comparable risk were offering 12.50%? Explain.

Explanation / Answer

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