Chapter 24 The Many Different Kinds of Debt 647
bre44380_ch24_618-651.indd 647 10/05/15 12:54 PM
- Convertible bonds Zenco, Inc. is financed by 3 million shares of common stock and by
$5 million face value of 8% convertible debt maturing in 2026. Each bond has a face value of
$1,000 and a conversion ratio of 200. What is the value of each convertible bond at maturity
if Zenco’s net assets are:
a. $30 million?
b. $4 million?
c. $20 million?
d. $5 million?
Draw a figure similar to Figure 24.4(c) showing how the value of each convertible bond at
maturity varies with Zenco’s net assets.CHALLENGE
- Tax benefits Dorlcote Milling has outstanding a $1 million 3% mortgage bond maturing in
10 years. The coupon on any new debt issued by the company is 10%. The finance director,
Mr. Tulliver, cannot decide whether there is a tax benefit to repurchasing the existing bonds
in the marketplace and replacing them with new 10% bonds. What do you think? Does it
matter whether bond investors are taxed? - 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. - Convertible bonds Occasionally it is said that issuing convertible bonds is better than
issuing stock when the firm’s shares are undervalued. Suppose that the financial man-
ager of the Butternut Furniture Company does have inside information indicating that the
Butternut stock price is too low. Butternut’s future earnings will in fact be higher than
investors expect. Suppose further that the inside information cannot be released without
giving away a valuable competitive secret. Clearly, selling shares at the present low price
would harm Butternut’s existing shareholders. Will they also lose if convertible bonds are
issued? If they do lose in this case, is the loss more or less than it would be if common
stock were issued?
Now suppose that investors forecast earnings accurately, but still undervalue the stock
because they overestimate Butternut’s actual business risk. Does this change your answers to
the questions posed in the preceding paragraph? Explain.