Risk and cost of capital of convertible bonds and straight bonds

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Chapter 20, Problem 7Q

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To discuss: Risk and cost of capital of convertible bonds and straight bonds

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Suppose a company simultaneously issues $50 million of convertible bonds with a couponrate of 9% and $50 million of nonconvertible bonds with a coupon rate of 12%. Bothbonds have the same maturity. Because the convertible issue has the lower coupon rate, isit less risky than the nonconvertible bond? Would you regard the cost of capital as beinglower on the convertible than on the nonconvertible bond? Explain. (Hint: Althoughit might appear at first glance that the convertible’s cost of capital is lower, this is notnecessarily the case, because the interest rate on the convertible understates its true cost.Think about this.)

Suppose a company simultaneously issues $50 million of convertiblebonds with a coupon rate of 10% and $50 million of straight bonds with acoupon rate of 14%. Both bonds have the same maturity. Does the convertible issue’s lower coupon rate suggest that it is less risky than the straightbond? Is the cost of capital lower on the convertible than on the straightbond? Explain.

Suppose that Verizon issues two bonds with identical coupon rates and maturity dates. One bond is callable, however, whereas the other is not. Callable bonds sell at a lower price. Describe in at most three sentences a market condition where Verizon can use callable bonds to reduce cost of debt capital?