O\'Brien Computers Inc. needs to rise $36 million to begin producing a new micro

Question

O'Brien Computers Inc. needs to rise $36 million to begin producing a new microcomputer. O'Bien nonconvertible debentures currently yield 14%. Its stock sells for $39 per share; the last dividend was $2.34; and the expected growth rate is a constant $7%. Investment bankers have tentatively proposed that O'Brien raise the $36 million by issuing convertible debentures. These convertibles would have a $1,000 par value, carry an annual coupon rate of 9%, have a 20-year maturity, and be convertible into 17 share of stock. The bonds would be noncallable for $4 per year in Year 6 and each year thereafter. Management has called convertibles in the past (and presumably will call them again in the future), once they were eligible for call, as soon as their conversion value was about 20% above their par value (not their call price).

Choose the graph, representing the expectations set forth in the problem.

The correct graph is A B C D?

Suppose the previously outlined projects work out on schedule for 2 years, but then O'Brien begins to experience extremely strong competition from Japanese firms. As a result, O'Brien's expected growth rate from 7% to zero. Assume that the dividend at the time of the drop is $2.68. The company's credit strength is not impaired, and its value of is also unchanged. What would happen (1) to the stock price and (2) to the convertible bond's price? Be as precise as you can. Round your answer to the nearest percent.

Percentage decline in stock price is %.____

Percentage decline of %____ in the value of the convertible

Explanation / Answer

1) Graph C is correct
2)
Price of stock just before change in growth expectation = Price at the end of 2nd year = P0 x (1 + r) ^2 = $39 x (1+ 7%)^2 = $44.65
Price of stock after changed growth expectations = Price at end of 3rd year = D0/ rate of return = $2.68/13.42% = $19.97
Rate of return calculated below
Rate of return is unchanged = r =(Dividend1/ Price )+growth = [$2.34 x (1+ 7%)]/$39 + 7% = 13.42%
Percentage decline in stock price is ($44.65 - 19.97)/$44.65 = 55.27%

Convertible bond
Bond Value before call
Face Value $1000
Coupon Rate = 9% = PMT = 1000 x 9% = 90
YTM = 14%
Maturity = (20 -2 ) years
Straight Bond Price = $676.63
Prior to the change in expected growth from 7 to 0 percent, the market value would have been above the straight bond value.According to the graph, the bond would sell for about $1,020. Thus, there would be a percentage decline of ($1020 - 676.63)/$1020 = 33.65 % in the value of the convertible.

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