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Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

14th Edition
Eugene F. Brigham + 1 other
ISBN: 9781285867977
Textbook Problem

Suppose a company simultaneously Issues $50 million of convertible bonds with a coupon rate of 9% and $50 million of nonconvertible bonds with a coupon rate of 12%. Both bonds have the same maturity. Because the convertible issue has the lower coupon rate, is it less risky than the nonconvertible bond? Would you regard the cost of capital as being lower on the convertible than on the nonconvertible bond? Explain. (Hint: Although it might appear at first glance that the convertible's cost of capital is lower, this is not necessarily the case, because the interest rate on the convertible understates its true cost. Think about this.)

Summary Introduction

To Discuss: Whether cost of capital is regarded as lesser on the convertible than on the nonconvertible bonds.

Introduction: A convertible bond is an debt instrument that the bondholder can exchange to the issuing organization for a particular number of its common stock shares. As it were, it's a bond that can be come back to the issuing organization in return for common stock shares.

Explanation

The reasons on whether cost of capital is regarded as lesser on the convertible than on the nonconvertible bond is as follows:

The convertible bond has a expected return that comprises of an yield rate of interest of 9% in addition to a expected capital gain. It is known that the expected capital gain must be somewhere around 3%, in light of the fact that the total expected return for the convertible must be at any rate equivalent when compared to the nonconvertible bond, 12%...

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