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.
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PRIN.OF CORPORATE FINANCE
- 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 bondarrow_forwardAssume a bank can invest in a government bonds at a risk-free rate of 5.6%. Alternatively, it can invest in a corporate bond with a default probability of 6.5%. If the issuer defaults, the bank expects to recover 28.3% of the investment. A risk-averse bank that requires an additional premium of 2.9% as a result of risk aversion would be indifferent between investing in the government bond and the corporate bond if the corporate bond offers a rate of __________. Calculate the answer by read surrounding text. %. Round to the nearest 0.01%, drop the % symbol. E.g., if your answer is 0.10245 or 10.245%, record it as 10.25.arrow_forwardBeacuase the conversion feature in a convertible bond is valuable to bondholders, convertible bond issues have lower coupon payments than otherwise similar bonds that are not convertible. Does this mean that a company can lower its cost of borrowingby selling convertible debt? explainarrow_forward
- A money market mutual fund manager is looking for some profitable investment opportunities and observes the following one-year interest rates on government securities and exchange rates: rUS = 12%, rUK = 9%, S = $1.50/£, f = $1.6/£, where S is the spot exchange rate and f is the forward exchange rate. Which of the two types of government securities would constitute a better investment?arrow_forwardFinance You own a convertible bond issued by a company and this gives you the option to switch the bond into a number of shares of that company at a date in the future. An event occurs which causes the value of the shares of the company to fall and the future volatility of the price of its shares to rise. The value of your convertible bond should: A Fall because the share price is lower. B Rise because there is more chance the option will be in the money. C Fall because default risk has risen.Fall because default risk has risen. D I do not wish to answer this question. E Could either rise or fall because two offsetting factors have occurred F Be unchanged because there is no reason to think default risk has changed.arrow_forwardassuming the government is selling a bond to fight COVID-19, and at the same time, ASHANTI Goldfields Company is selling a corporate bond to increase its production. IUnder what conditions will a production-linked corporate bond be over subscribed at the expense of the government bond. Explore all possible scenariosarrow_forward
- After Dan’s EFN analysis for East Coast Yachts (see the Closing Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $45 million in new 30-year bonds to finance new construction. Dan has entered into discussions with Renata Harper, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. Dan is also considering whether to issue coupon-bearing bonds or zero coupon bonds. The YTM on either bond issue will be 5.5 percent. The coupon bond would have a 5.5 percent coupon rate. The company’s tax rate is 21 percent. How many of the coupon bonds must East Coast Yachts issue to raise the $45 million? How many of the zeroes…arrow_forwardYour business associate mentions that she is considering investing in corporate bonds currently selling at a premium. She says that because the bonds are selling at a premium, they are highly valued and her investment will yield more than the going rate of return for the risk involved. Reply with a memorandum to confirm or correct your associate’s interpretation of premium bonds.arrow_forwardTrue of False Bond holders have voting rights and common shareholders do not. Because the likelihood of the U.S. Government paying back their debts is nearly 100%, U.S. bonds are classified as "risk free" investments. In general, a project or investment with a high standard deviation is viewed as less risky than one with a low standard deviation. When the present value of a bond exceeds the future value of the bond, it is selling at a premium. Preferred stock has an advantage over common stock because preferred shareholders have voting rights and common stock holders do not.arrow_forward
- Mini Case: FINANCING EAST COAST YACHTS’S EXPANSION PLANS WITH A BOND ISSUE After Dan’s EFN analysis for East Coast Yachts (see the Mini Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $40 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Kim McKenzie, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. Respond to the following questions: 1. You are Kim’s assistant, and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. She would also like you to list any advantages or…arrow_forwardQuestion 2: What Would Your Finance Manager Say?Ike Intern stated, “Our firm should always issue bonds when the market rate of interest is greater than the stated rate of interest. By doing so, we would make lower periodic cash payments for interest.” Irene Intern countered, “You’re wrong. We should issue bonds only when the market rate of interest is less than the stated rate of interest. If we did, we could sell bonds at a premium and receive more cash.” What would Ike and Irene’s Finance Manager say? Question 3: Theory Vs. PracticeAs discussed in the chapter, preferred stock offers an investor certain preferences over common stock in relation to dividends and liquidation value. In theory, these preferences should make preferred shares more attractive to potential investors than common stock. In practice, however, a majority of companies do not issue preferred stock, and most investors seem to favor putting their investment dollars into common shares. Discuss some of the reasons a…arrow_forwardFINANCING EAST COAST YACHTS’S EXPANSION PLANS WITH A BOND ISSUE After Dan’s EFN analysis for East Coast Yachts (see the Mini Case in Chapter 3), Larissa has decided to expand the company’s operations. She has asked Dan to enlist an underwriter to help sell $50 million in new 20-year bonds to finance new construction. Dan has entered into discussions with Kendahl Shoemaker, an underwriter from the firm of Crowe & Mallard, about which bond features East Coast Yachts should consider and also what coupon rate the issue will likely have. Although Dan is aware of bond features, he is uncertain as to the costs and benefits of some of them, so he isn’t clear on how each feature would affect the coupon rate of the bond issue. 1.You are Kendahl’s assistant and she has asked you to prepare a memo to Dan describing the effect of each of the following bond features on the coupon rate of the bond. She also would like you to list any advantages or disadvantages of each feature. a.The security…arrow_forward