PRIN.OF CORPORATE FINANCE
13th Edition
ISBN: 9781260013900
Author: BREALEY
Publisher: RENT MCG
expand_more
expand_more
format_list_bulleted
Videos
Textbook Question
Chapter 24, Problem 27PS
Convertible bonds This question illustrates that when there is scope for the firm to vary its risk, lenders may be more prepared to lend if they are offered a piece of the action through the issue of a convertible bond. Ms. Blavatsky is proposing to form a new start-up firm with initial assets of $10 million. She can invest this money in one of two projects. Each has the same expected payoff, but one has more risk than the other. The relatively safe project offers a 40% chance of a $12.5 million payoff and a 60% chance of an $8 million payoff. The risky project offers a 40% chance of a $20 million payoff and a 60% chance of a $5 million payoff.
Ms. Blavatsky initially proposes to finance the firm by an issue of straight debt with a promised payoff of $7 million. Ms. Blavatsky will receive any remaining payoff. Show the possible payoffs to the lender and to Ms. Blavatsky if (a) she chooses the safe project and (b) she chooses the risky project. Which project is Ms. Blavatsky likely to choose? Which will the lender want her to choose?
Suppose now that Ms. Blavatsky offers to make the debt convertible into 50% of the value of the firm. Show that in this case the lender receives the same expected payoff from the two projects.
Expert Solution & Answer
Want to see the full answer?
Check out a sample textbook solution
Students have asked these similar questions
Problem 3 There are two types of banks, A and B. Each bank has 20 loans. Each loan of
type A bank generates $500 with probability 0.9 and $200 with probability 0.1, and these
cash flows are independently distributed. Each loan of the type B bank generates $600
with probability 0.4 and $200 with probability 0.6, and these cash flows are independently
distributed, too. Suppose that the bank XYZ is type A. However, the investors believe
that XYZ is type A with probability 0.3 and type B with probability 0.7. Ignore investors'
opportunity cost of investment (or assume that that the risk-free interest rate is 0%.) The
investors are risk neutral. Consider the following securitization options for the bank XYZ.
1
a. Suppose XYZ wants to securitize the portfolio of loans as a single security without
communication. What is the market price of the security issued by XYZ? What is
the net payoff to XYZ generated by this securitization?
b. Suppose XYZ wants to securitize the portfolio of loans as a…
Company PLU decides to issue bond to finance its investment in a project. However, the project is only expected to start to generate income from year 4 onwards. Considering this, which of the following bonds is favoured by the company? Please explain your answer.
Plain vanilla bond
Step-up coupon bond
Deferred coupon bond
Credit linked coupon bond
From an investment point of view, bonds are generally considered to be safer investments than stocks. They are generally low risk low return investments, unlike stocks. As an investor in bonds, you would lend money to the issuer of the bonds. It is important to understand what bonds are and how they work as investment vehicles.
Suppose a friend of yours is looking to invest $5,000 such that it will provide current income and increase the diversification of his assets. He has heard a lot about corporate bonds but wants to learn more before purchasing them. Fill in the blanks in the following conversation to give your friend the appropriate information regarding corporate bonds.
FRIEND: Can you explain to me the basics of how investing in a corporate bond will increase my current income?
YOU: Under a standard bond agreement, if you were to purchase a 10-year, $5,000 corporate bond with a 9% coupon, you would receive _______________in interest each year, and at the end of…
Chapter 24 Solutions
PRIN.OF CORPORATE FINANCE
Ch. 24 - Bond terms Use Table 24.1 (but not the text) to...Ch. 24 - Bond terms Look at Table 24.1: a. The AMAT bond...Ch. 24 - Bond terms Select the most appropriate term from...Ch. 24 - Prob. 5PSCh. 24 - Bond terms Bond prices can fall either because of...Ch. 24 - Security and seniority a. As a senior bondholder,...Ch. 24 - Prob. 8PSCh. 24 - Prob. 9PSCh. 24 - Security and seniority a. Residential mortgages...Ch. 24 - Sinking funds For each of the following sinking...
Ch. 24 - Call provisions a. Look at Table 24.1. Suppose...Ch. 24 - Covenants Alpha Corp. is prohibited from issuing...Ch. 24 - Prob. 14PSCh. 24 - Private placements Explain the three principal...Ch. 24 - Convertible bonds True or false? a. Convertible...Ch. 24 - Convertible bonds Maple Aircraft has issued a 4%...Ch. 24 - Convertible bonds The Surplus Value Company had 10...Ch. 24 - Prob. 19PSCh. 24 - Convertible bonds Iota Microsystems 10%...Ch. 24 - Convertible bonds Zenco Inc. is financed by 3...Ch. 24 - Prob. 22PSCh. 24 - Prob. 23PSCh. 24 - Bank loans, commercial paper, and medium-term...Ch. 24 - Prob. 25PSCh. 24 - Tax benefits Dorlcote Milling has outstanding a 1...Ch. 24 - Convertible bonds This question illustrates that...Ch. 24 - Prob. 28PS
Knowledge Booster
Learn more about
Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- From an investment point of view, bonds are generally considered to be safer investments than stocks. They are generally low risk low return investments, unlike stocks. As an investor in bonds, you would lend money to the issuer of the bonds. It is important to understand what bonds are and how they work as investment vehicles. Suppose a friend of yours is looking to invest $5,000 such that it will provide current income and increase the diversification of his assets. He has heard a lot about corporate bonds but wants to learn more before purchasing them. Fill in the blanks in the following conversation to give your friend the appropriate information regarding corporate bonds. FRIEND: Can you explain to me the basics of how investing in a corporate bond will increase my current income? YOU: Under a standard bond agreement, if you were to purchase a 10-year, $5,000 corporate bond with a 9% coupon, you would receive in interest each year, and at the end of the 10-year…arrow_forwardETFs are the most popular investment instruments for individual and institutional investors. You are interviewing with a FinTech firm that creates bond ETFs. Make a pitch for how you will design Bond ETFs that offer something unique and that are able to stand out in the crowd given the proliferation of bonds ETFs in the market. Keep in mind that bond values depend on, (a) bond ratings, and (b) the macroeconomic environment. Also keep in mind the relation between the promised payments and interest-rate risk; indenture/structured provisions and agency theory; the concept of over and underpriced bonds; the concept of hidden risk; the importance of being able to predict the macro environment; and the importance of AI and ML in a robo-advising context.arrow_forwardBanker’s Acceptances allow corporations in different countries to trade with each other because they have very close relationship and trust each other. True False The yield to maturity is the annualized discount rate that equates the future coupon and principal payments to the initial proceeds received from the bond offering. True Falsearrow_forward
- Mr. Jackson is considering investing in corporate bonds. He has talked to an investment analyst who has advised him to choose between company A or company B bonds. The possible rates of return for the two bonds, which are subject to the state of the economy are given below: State of theeconomy Probability for State ofthe economy Possible rate of returnfor Company A bond Possible rate ofreturn for CompanyB bond Expansion 0.2 17% 20% Normal 0.1 13% 15% Recession 0.4 10% 11% Required:i. Calculate the expected return for each corporate bond ii. Calculate the variance and standard deviation for each bond. iii. Compute the coefficient of variation for each bond iv. Advice Mr. Jackson on the best bond to invest in.arrow_forwardQuestion What is primary and secondary market? An IPO is undertaken on primary or secondary market? What is the essential job of an investment banker? Why a stock exchange is called an auction market? What are the five basis principles of finance? Your company is considering choosing one of the two projects: Project Gold and Project Diamond. Each project will last 5 years and have no salvage value at the end. The company’s required rate of return for all investment projects is 9%. The cash flows of the two projects are provided below. Gold Diamond Cost $485 000 $520 000 Future Cash Flows Year 1 Year 2 Year 3 Year 4 Year 5 105 850 153 250 225 650 245 000 250 350 117 050 162 400 275 500 255 000 260 000 Required: Identify which project should your company accept based on Discounted Payback Period method if the payback criterion is maximum of 2.5 years.arrow_forwardEstablish a finance plan that assumes the sales estimates at the take price level would have been increased by $500,000. This means that the current take price level of $9,170,000 would increase by $500,000. This change would offer more collateral to the bank, and the bank would then increase the GAP loan. The GAP loan requires 200% collateral in unsold rights. This change would impact the equity investment. Question: What would be the new equity investment be if the budget stays the same?arrow_forward
- The company's bank won't lend it any more money than it already has, and investment bankers have said that debentures are out of the question. The treasurer has asked you to do some research and suggest a few ways in which bonds might be made attractive enough to allow the company to borrow. What does providing a restrictive indenture limiting the risk in future undertakings do? How does it make the bonds more attractive? Explain in great detail.arrow_forwardThe reading below deals with some typical swaption strategies and the factors that originate them. First, read it carefully. Lehman Brothers and Credit Suisse First Boston are recommending clients to buy long-dated swaption vol ahead of the upcoming US Federal Open Markets Committee meeting. In the trade, the banks are recommending clients to buy long-dated swaption straddles, whose value increases if long-dated swaption vol rises. Mortgage servicers and investors are keen to hedge refinancing risk with swaptions as interest rates fall, meaning that long-dated swaption vol should rise over the next several months, said an official at CSFB in New York. The traditional supply of swaption vol has been steadily decreasing over the last year, said (a trader) in New York. Agencies supply vol to dealers mainly via entering swaps with embedded options on the back of issuing callable notes. Over the past year, demand for callable notes has been decreasing due to high interest rate volatility,…arrow_forward(a) Company PLU decides to issue bond to finance its investment in a project. However, the project is only expected to start to generate income from year 4 onwards.Considering this, which of the following bonds is favoured by the company? Please explain your answer. Plain vanilla bond Step-up coupon bond Deferred coupon bond Credit linked coupon bond (b) An affirmative covenant is most likely to stipulate: 1) Limits on the issuer’s leverage ratio. 2) How the proceeds of the bond issue will be used. 3) The maximum percentage of the issuer’s gross assets that can be sold. (c) Suppose a bond’s price is expected to decrease by 3% if its market discount rate increases by 50 bps. If the bond’s market discount rate decreases by 50 bps, the bond price is most likely to change by: 3% Less than 3% More than 3% What is the best terminology to describe this pattern (use terminology covered in this unit)? Please explain your answer. (d) Assume that bonds ABC and XYZ are zero…arrow_forward
- If a firm expects to have additional financial requirements in the future,would you recommend that it use convertibles or bonds with warrants?What factors would influence your decision?arrow_forwardIndicate whether each of the following statements is true or false. Support your answers with the relevant explanations. Modigliani and Miller’s Proposition II assumes that increased borrowing does not affect the interest rate on the firm’s debt. (Explain your reasoning.) Under the conditions of perfect capital markets, the cost of capital of a company financed fully by equity is expected to be equal to that of the same company but financed with 50% equity and 50% debt. (Explain your reasoning.) 3. The higher the systematic risk of a company’s stock, the higher the value of its beta. The higher the beta, the higher the return required by the investors. (Explain your reasoning.) 4. The higher the proportion of equity in a company’s overall capital structure, the higher return required by its debtholders. (Explain your reasoning – in your explanation, provide a numerical example supporting your answer.) 5.In the presence of corporate taxes, a company would prefer to raise…arrow_forward6. You are thinking of buying a bond from Bluestone Corporation. You know that this bond is long term and you know that Bluestone's business ventures are risky and uncertain, You then consider another bond with a shorter term to maturity issued by a company with good prospects and an established reputation. Which of the following is correct? a. The longer term would tend to make the interest rate on the bond issued by Bluestone higher, while the higher risk would tend to make the interest rate lower. b. The longer term would tend to make the interest rate on the bond issued by Bluestone lower, while the higher risk would tend to make the interest rate higher. c. Both the longer term and the higher risk would tend to make the interest rate lower on the bond issued by Bluestone. d. Both the longer term and the higher risk would tend to make the interest rate higher on the bond issued by Bluestone. 7. The unemployment rate is computed as the number of unemployed a. divided by the labor…arrow_forward
arrow_back_ios
SEE MORE QUESTIONS
arrow_forward_ios
Recommended textbooks for you
Intermediate Financial Management (MindTap Course...FinanceISBN:9781337395083Author:Eugene F. Brigham, Phillip R. DavesPublisher:Cengage Learning
Intermediate Financial Management (MindTap Course...
Finance
ISBN:9781337395083
Author:Eugene F. Brigham, Phillip R. Daves
Publisher:Cengage Learning
Journalizing Bonds Payable/Amortization of a Premium; Author: TLC Tutoring;https://www.youtube.com/watch?v=5gEpAFFnIE8;License: Standard YouTube License, CC-BY
Investing Basics: Bonds; Author: TD Ameritrade;https://www.youtube.com/watch?v=IuyejHOGCro;License: Standard YouTube License, CC-BY