Chapter 20, Problem 14IC

### Fundamentals of Financial Manageme...

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

Chapter
Section

### Fundamentals of Financial Manageme...

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

# PREFERRED STOCK, WARRANTS, AND CONVERTIBLES Martha Millon, financial manager of Fish & Chips Inc., is facing a dilemma. The firm was founded 5 years ago to develop a new fast-food concept; and although Fish & Chips has done well, the firm′s founder and chairman believes that an industry shake-mil is imminent. To survive, the firm must capture market share now, which requires a large infusion of new capital.Because the stock price may rise rapidly. Millon does not want to issue new common stock. On the other hand, interest rates are currently very high by historical standards, and with the firm′s B rating, the interest payments on a new debt issue would be too much to handle if sales took a downturn. Thus, Millon has narrowed her choice to bonds with warrants or convertible bonds. She has asked you to help in the decision process by answering the following questions.a. How does preferred stock differ from common equity and debt?b. What is adjustable-rate preferred?c. How can a knowledge of call options help a person understand warrants and convertibles?d. One of Millon′s alternatives is to issue a bond with warrants attached. Fish & Chips′s current stock price is S10, and the company′s investment bankers estimate its cost of 20-year annual coupon debt without warrants to be 12%. The bankers suggest attaching 50 warrants to each bond, with each warrant having an exercise price of $12.50. It is estimated that each warrant, whim detached and traded separately, will have a value of$1 -50. 1. What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000? 2. Suppose the bonds are issued and the warrants immediately trade for$2.50 each. What does this imply about the terms of the issue? Did the company "win” or “lose"? 3. When would you expect the warrants to be exercised? 4. Will the warrants bring in additional capital when exercised? If so, how much and what type of capital? 5. Because warrants lower the cost of the accompanying debt, shouldn′t all debt be issued with warrants? What is the expected cost of the bond with warrants if the warrants an- expected to be exercised in 5 years, when Fish & Chips′s stock price is expected to be $17.50? How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock? e. As an alternative to the bond with warrants. Millon is considering convertible bonds. The firm′s investment bankers estimate that Fish & Chips could sell a 20-year, 10% annual coupon, callable convertible bond for its$1,000 par value, whereas a straight-debt issue would require a 12% coupon. Fish & Chips′s current stock price is $10, its last dividend was$0.74, and the dividend is expected to grow at a constant rate of 8%. The convertible could be converted into 80 shares of Fish & Chips stock al the owner′s option. 1. What conversion price, P, is implied in the convertible′s terms? 2. What is the- straight-debt values of the convertible? What is the implied value of the convertibility feature? 3. What is the formula for the bond′s conversion value in any year? Its value at Year 0? At Year 10? 4. What is meant by the term floor value of a convertible? What is the convertible′s expected floor value in Year 0? In Year 10? 5. Assume that Fish & Chips intends to force conversion by calling the bond when its conversion value is 20% above it′s par value, or at 1.2($1,000) =$1,200. When is the issue expected to be called? Answer to the closest year. 6. What is the expected cost of the convertible to Fish & Chips? Does this cost appear consistent with the risk of the issue? Assume conversion in Year 5 at a conversion value of \$1,200. f. Millon believes that the cost of the bond with warrants and the cost of the convertible bond arc essentially equal, so her decision must be based on other factors. What are some factors she should consider when making her decision between the two securities?

a.

Summary Introduction

To discuss: The preferred stock differs from debt and common equity.

Introduction:

Stock is a type of security in a company that denotes ownership. The company can raise the capital by issuing stocks.

Explanation

The preferred stock differs from debt and common equity is as follows:

Preferred stock can be termed as hybrid stock because it is similar characteristically with common equity and debt. The preferred payments made to the investors remain contractually stable resembling debt whereas like common equity the non-payment of dividend does amount to default and bankruptcy...

b.

Summary Introduction

To discuss: The meaning of adjustable-rate preferred.

c.

Summary Introduction

To discuss: The knowledge of call options helps people to understand convertibles and warrants.

Introduction:

Option is a contract to purchase a financial asset from one party and sell it to another party on an agreed price for a future date. There are two types of options, which are as follows:

• An option that buys an asset called call option
• An option that sells an asset called put option

d.1.

Summary Introduction

To determine: The coupon rate that is set on the bond with warrants.

Introduction:

A warrant is securities that give the bondholder the right, yet not the obligation, to purchase a specific number of securities at a specific cost before a particular period.

d.2.

Summary Introduction

To discuss: The implication of terms of issues and whether the company loses or wins.

d.3.

Summary Introduction

To discuss: The expected period when the warrants to be exercised.

d.4.

Summary Introduction

To discuss: Whether the warrants will bring in additional capital when exercised and determine the type of capital.

d.5.

Summary Introduction

To discuss: Whether all the debt been issued with warrants when the warrants lower the cost of debt and determine the expected cost of the bond with warrants.

Summary Introduction

To discuss: The comparison on the cost of bond with warrants by the cost of straight debt and cost of common stock.

e.1.

Summary Introduction

To determine: The conversion price and whether ot is implied in the convertible’s terms.

e.2.

Summary Introduction

To determine: The straight-debt value of the convertible and implied value of the convertibility.

e.3.

Summary Introduction

To determine: The formula for the conversion value of bond in any year and even compute the value of conversion at Year 0 and Year 10.

e.4.

Summary Introduction

To discuss: The meaning of the term floor value of a convertible and compute the convertible’s expected floor value in the Year 0 and Year 10.

e.5.

Summary Introduction

To determine: The number of year or period when the issue is expected to callable.

e.6.

Summary Introduction

To determine: The expected cost of the convertible and whether the cost appears consistent with the risk of the issue.

f.

Summary Introduction

To discuss: The factors that Person M as to consider on making decision between to securities.

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