Chapter 20, Problem 8SP

Start with the partial model in the file Ch20 P08 Build a Model.xlsx on the textbook’s Web site. Maggie’s Magazines (MM) has straight nonconvertible bonds that currently yield 9%. MM’s stock sells for $22 per share, has an expected constant growth rate of 6%, and has a dividend yield of 4%. MM plans on issuing convertible bonds that will have a $1,000 par value, a coupon rate of 8%, a 20-year maturity, and a conversion ratio of 32 (i.e., each bond could be convertible into 32 shares of stock). Coupon payments will be made annually. The bonds will be noncallable for 5 years, after which they will be callable at a price of $1,090; this call price would decline by $6 per year in Year 6 and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Management will call the bonds when their conversion value exceeds 25% of their par value (not their call price).

1. a. For each year, calculate (1) the anticipated stock price, (2) the anticipated conversion value, (3) the anticipated straight-bond price, and (4) the cash flow to the investor assuming conversion occurs. At what year do you expect the bonds will be forced into conversion with a call? What is the bond’s value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because the conversion occurs immediately after the coupon is paid.)
2. b. What is the expected rate of return (i.e., the before-tax component cost) on the proposed convertible issue?
3. c. Assume that the convertible bondholders require a 9% rate of return. If the coupon rate remains unchanged, then what conversion ratio will give a bond price of $1,000?