Question: Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. T

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Question: Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years... Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm’s founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital. Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firm’s B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds. As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions. c. Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and focus on the others. EduSoft's investment banker estimates that EduSoft could issue a bond-with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a strike price of $25 and 10 years until expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%. 1) What coupon rate should be set on the bond with warrants if the total package is to sell at par ($1,000)? 2) When would you expect the warrants to be exercised? What is stepped-up exercise price? 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 stocks will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding.) 4) Because the presence of warrants results in a lower coupon rate on the accompanying debt issue, should not all debt be issued with warrants? To answerthis, estimate the anticipated stock price in 10 years when the warrants are expected to be exercised, and 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 excpted to grow at 8% per year. 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%)? 6) If the corporate tax rate is 40%, what is the after-tax cost of the bond with warrants?

Explanation / Answer

c)

If the entire issue is to be sold at $ 1,000

Pissues = Pbonds + Pwarrants = 1000

there are 27 warrants at $ 5 each

Pwarrants = 27 * 5 = $ 135

Pissues = Pbonds + Pwarrants = 1000

1000 = Pbonds + 135 = $ 865

the coupon rate must be in such a way that the bond is sold at $ 865

here rate of debt = 10%, and if the coupon rate is 10 % then the debt is sold at par(basically $ 1000) not at $ 865.

so rationally we can get to a conclusion that coupon rate is below 10%

so we need to find the coupon amount now.

Here we can use financial calculator(say BA II plus)

Inpiut the values;

N = 20 (20 year bond), I/Y = 10%, FV = 1000, PV = - 865 (As calculated above)

Note : give negetive sign for PV as it is a cash ouflow

compute for PMT,

we get

PMT = $ 84.13 roughly $ 84.

Hence the coupon rate = 8.4%

so we can conclude that 27 warrents and a bond(costing 865) would sum up to a total cost of 1000.

2)

A warrant would be sold in an open market at a premium above its exercise value. Thus, prior to expiration, an investor who wanted cash would sell his warrants in the marketplace rather than exercise them. Therefore, warrants tend not to be exercised until just before they expire. In order to motivate an investor to exercise the warrants to bring in equity capital, some warrants contains step up provision. In this the strike increases in gradually over the life of the warrant. Since the value of the warrant falls when the strike price is increased, step up provisions encourage warrant holders to exercise just prior to the timing of a step up process.

Warrant holders may exercise the warrants if the dividend on the stock rises. No dividend is earned on a warrant, and high dividends increase the attractiveness of stocks over warrants. The expiration value of the warrant will fall if the stock price falls, and stock prices fall when the stock goes ex dividend. If the dividend is large, warrant holders can avoid huge losses by exercising the warrants.

3)

A single warrant will bring in an amount equal to the strike price, here it means $25 of equity capital, and holders will receive one share of common stock per warrant.

Number of warrants/bond = 27

Number of bonds = 100,000

Strike price = 25

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

27 x 100,000 x 25 = 67,500,000

Stocks before excersising the warrants = 20 million

New shares created by executing the warrant option = (Number of warrants/bond) x (Number of bonds)

= 2700000 = 2.7 million

total shares at the end of 10 years of maturity = 20+ 2.7 = 22.7 million

6)

Tax rate = T = 40% = 0.4

after tax coupon payment = 84 ( 1 - T )

hence the coupon payment = 84 ( 1-0.4)

= 50.4

now use the financial calculator

N = 20, PMT =50.4, PV = -865, FV = 1000, solve for I/Y

compute

we get

I/Y = 6.24%

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