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.)