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 a 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 stock will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding.)
- 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 a 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 stock 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, shouldn’t all debt be issued with warrants? To answer this, 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 expected 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 25%, what is the after-tax cost of the bond with warrants?
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