Chapter 19 Discussion Questions 19-1. These are all derivatives that have value based to a large extent on the value of an underlying asset. All are used to reduce risk (hedge) or to take on risk (speculate). • Forwards are customized contracts (as to the amount and future delivery (exercise) date) between two parties for the future delivery of any asset. These contracts almost always must be exercised. • Futures are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange. • Options are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange. The holder can also let them expire if they have no further use, unlike forwards or futures. 19-2. A firm may force conversion of a bond issue through the use of the call privilege. If a bond has had a substantial gain in value due to an increase in price of the underlying common stock, the bondholder may prefer to convert to common stock rather than trade in the bond at some small premium over par as stipulated in a call agreement. 19-3. The advantages to the corporation of a convertible security are: a. The interest rate is lower than on a straight issue. b. This type of security may be the only device for allowing a small firm access to the capital markets. c. The convertible allows the firm to effectively sell stock at a higher price than that possible when the bond was initially issued (but perhaps at a lower price than future price potential might provide). 19-4. Basic earnings per share considers none of the potentially dilutive effects of convertibles, warrants, and other securities that can generate new shares of common stock. Fully diluted earnings per share considers all dilutive effects regardless of their origin. Adjustment includes: a. Numerator adjustment includes dividends payable on convertible preferred shares, aftertax interest on convertible debt and inputed aftertax interest earned on cash that would have been received from rights, warrants, and options if they had been exercised. b. Denominator includes all common shares outstanding and equivalent shares of all convertible preferreds and bonds and common shares issued if rights, warrants and options exercised. 19-5. Investors are willing to pay a premium over the theoretical value for a convertible preferred share issue because of the future prospects for the associated common stock. Thus, if there are many years remaining for the conversion privilege, the investor will be able to receive a reasonably high dividend rate and still have the existing option of going to common stock if circumstances justify. 19-6. The floor price of a convertible is based on the pure bond value associated with the interest payments on the bond as shown in Figure 19-1. Regardless of how low the associated common stock might go, the semiannual interest payments will set a floor price for the bond. For convertible preferreds, the guaranteed dividend payment does the same thing. 19-7. a. The strength of the underlying securities that can be substituted for the convertible. b. A decrease in long-term yields would primarily affect convertible securities trading on the strength of the dividend or interest yield, compared to securities trading on the common share value. 19-8. A "step-up" in conversion price means the conversion price will increase with the passage of time and likewise the conversion ratio will decline. Before each step-up, there is an inducement for bondholders to convert to common at the more desirable price. 19-9. To determine fully diluted earnings per share when convertibles are present, we add aftertax savings from the reduced interest or dividend obligation on ‘assumed conversion’ to normally computed earnings aftertaxes. For example, if $450,000 in interest could be saved on an assumed conversion of bonds to 100,000 common shares, we would add $270,000 to the numerator (assuming a 40 percent tax rate) and 100,000 into the denominator. For warrants, we must compute the number of new shares that could be created by the exercise of all outstanding warrants and compute the return expected on the proceeds received from the exercise of the warrants. 19-10. Convertible bonds and warrants are similar in that they give the security holder a future option on the common stock of the corporation. They are dissimilar in that a convertible bond represents a debt obligation of the firm as well. When it is converted to common stock, corporate debt will actually be reduced and the capitalization of the firm will not increase. A warrant is different in that it is not a valuable instrument on its own merits, and also its exercise will increase the overall capitalization of the firm. 19-11. Warrants may be used to sweeten a debt offering or as part of a merger offer or a bankruptcy proceeding. 19-12. Warrants may sell above their intrinsic value because the investor views the associated stock's prospects as being bright, or because there is a reasonable amount of time to run before the warrant expires. Warrants also allow for the use of leveraged investing. 19-13. The speculative premium will be larger the longer the time to maturity, the higher the time value of money (a warrant is more valuable as only a downpayment), the greater the volatility of the underlying security (a greater chance of gain) and the closer the exercise price is to the market price of the underlying security (the greatest leverage opportunity). Dividends on the underlying security will dampen the speculative premium. 19-14. Put warrants go up in value as the underlying security decreases in value. Financial intermediaries have at various times offered these securities. Internet Resources and Questions 1. 2. 3. 4. 5. http://fx.sauder.ubc.ca www.cmegroup.com (see problem #2 for format) www.cmegroup.com (see problem #3 for format) www.cmegroup.com (see problem # 3 for format) www.tmx.com www.m-x.ca/accueil_fr.php (see problem #4 for format) www.tmx.com www.m-x.ca/accueil_fr.php (see problem #4 for format Problems 19-1. Giffen Forest Products The forward rate will produce $ Canadian = £ 155,000 × 1.5683 = $243,087 No payment is required today, only at the forward date. Forwards are usually executed through financial institutions, usually banks. They may require a good faith deposit or appropriate security to insure the completion of the contract. 19-2. Western Farmer a. In Septemberr Sell canola at: Cash (spot) rate Close out future: Future (Sept. expiry) Sold at (May) Purchase at (Sept.) Loss on future Total revenues with: Cash market and future b. In September Sell canola at: Cash (spot) rate Close out future: Future (Sept. expiry) Sold at (May) Purchase at (Sept.) Gain on future Total revenues with: Cash market and future Canola price ($ Cdn. / tonne) Cash received 1,000 tonnes $590 $590,000 $576 615 $(39) $576,000 615,000 $(39,000) $576,000 ($615,000 ̶ $39,000) Canola price ($ Cdn. / tonne) Cash received 1,000 tonnes $590 $590,000 $576 540 $ 36 $576,000 540,000 $ 36,000 $576,000 ($540000 + $36,000) Regardless of price movement up or down you, the farmer, have locked in a price of $576,000 (September cash price – purchase, plus gain/loss on future). Your risk is reduced and you can plan based on this expected receipt for your canola. There will be some differences in practice as the future price and cash prices are rarely identical as in this example. 19-3. Jewelry Manufacturer a. In April Purchase gold at: Cash (spot) rate Close out future: Future (April expiry) Sold at (April) Purchase at (June) Loss on future Total payment with: Cash market and future b. In April Purchase gold at: Cash (spot) rate Close out future: Future (April expiry) Sold at (April) Purchase at (June) Loss on future Total payment with: Cash market and future Gold price ($ U.S. / ounce) Cash payment 500 ounces $1,882 $941,000 $1,895 2,250 $ 355 $ 947,500 1,125,000 $ (177,500) $947,500 ($1,125,000 ̶ $177,500) Gold price ($ U.S. / ounce) Cash payment 500 ounces $1,882 $941,000 $1,895 1,525 $ 370 $947,500 762,500 $185,000 $947,500 ($762,500 + $185,000) 19-4. July 2004 Options a. Calls Abracadabra Cinder I-invest Tomato 1 Share Price 2 Strike Price $58.85 45.10 8.01 39.87 $50.00 45.00 8.00 40.00 1 Share Price 2 Strike Price $58.85 45.10 8.01 39.87 $50.00 45.00 8.00 40.00 3 Intrinsic Value (1 − 2) $8.85 0.10 0.01 0.00 4 Call Option Price $13.30 2.40 1.70 2.85 5 Speculative Premium (4 − 3) $4.45 2.30 1.69 2.85 3 Intrinsic Value (2 − 1) $0.00 0.00 0.00 0.13 4 Put Option Price $2.95 2.30 1.50 2.70 5 Speculative Premium (4 − 3) $2.95 2.30 1.50 2.57 b. Puts Abracadabra Cinder I-invest Tomato c. Abracadabra Share price = $70.00 Call option price Put option price d. Abracadabra Put option price = Intrinsic value + speculative premium = ($70 − $50) + $0.50 = $20.50 = Intrinsic value + speculative premium = ($50 − $70) + $0.50 = $0.00 + $0.50 = $0.50 Share price = $45.00 Call option price Strike price = $50.00 Strike price = $50.00 = Intrinsic value + speculative premium = ($45 − $50) + $1.25 = $0.00 + $1.25 = $1.25 = Intrinsic value + speculative premium = ($50 − $45) + $1.25 = $5.00 + $1.25 = $6.25 19-5. DNA Labs, Inc. a. $26.75 stock price × 40 shares = $1,070.00 conversion value b. $1,118.50 bond price – $1,070.00 conversion value = $48.50 conversion premium c. $1,000 par value/ 40 conversion ratio = $25 conversion price 19-6. Claypot Ceramics Company a. $8.95 stock price × 100 shares = $895.00 conversion value b. $980.00 bond price – $895.00 conversion value = $85 conversion premium c. $1,000 par value/ 100 conversion ratio = $10 conversion price 19-7. Stein Company First compute the conversion ratio. The conversion ratio is equal to the par value ÷ the conversion price: Par value/ conversion price $1,000/ $20 = conversion ratio = 50 conversion ratio Multiply the common stock price times the conversion ratio to get the conversion value: Common stock price × conversion ratio = conversion value $18.50 × 50 shares = $925 conversion value Add the conversion premium to the conversion value to arrive at the convertible bond price: Conversion Value + Conversion Premium = Convertible Bond Price = $925 + $35 = $960 convertible bond price 19-8. Sherwood Forest Products a. $1,000 par value/ 25 conversion ratio = $40 conversion price $35 common stock price × 25 shares = $875 conversion value $950 bond price – $875 = $75 conversion premium b. $950 bond price/ 25 shares = $38 19-9. Hamilton Steel Company a. Par value/ conversion price $1,000/ $50 = conversion ratio = 20 20 shares × $44 common stock price = $880 conversion value b. Pure bond value: Calculator: Compute: PV =? FV = 1,000 %I/Y = 5% (10%/ 2) PV = $817.44 19-10. PMT = $40 ($80/2) N = 50 (25 × 2) Hamilton Steel Revisited Pure bond value: Calculator: Compute: PV =? FV = 1,000 %I/Y = 6% (12%/ 2) PV = $684.76 PMT = $40 ($80/2) N = 50 (25 × 2) 19-11. Olsen Mining Company a. $39.50 stock price × 32 shares = $1,264 conversion value + 10 conversion premium $1,274 Bond price b. 5% × $1,000 = $50 Annual interest Current yield = c. Calculator: Compute: Annual interest $50 = = 0.0392 = 3.92% Bond price $1,274 PV =$1,274 FV = 1,000 PMT = $25 ($50/2) %I/Y =? N = 14 (7 × 2) %I/Y = 0.047 × 2 = 0.95% (annual) d. $21.50 stock price × 32 shares = $ 688 conversion value + 100 conversion premium $ 788 Bond price Calculator: Compute: PV =$788 FV = 1,000 PMT = $25 ($50/2) %I/Y =? N = 14 (7 × 2) %I/Y = 4.585 × 2 = 9.17% (annual) 19-12. Standard Olive Company of B.C. a. $1,000 par value/ 25 conversion ratio = $40 conversion price b. $30.00 stock price × 25 conversion ratio = $750 conversion value c. Pure bond value: Calculator: Compute: PV =? FV= 1,000 %I/Y = 5% (10%/2) PV = $923.14 PMT = $45 ($90/2) N = 30 (15 × 2) d. 200 180 160 Conversion value 140 Pure bond value 120 $923.14 Bond values 100 Floor value 80 60 40 20 0 0 1 2 3 4 5 Price of common shares e. Most likely, the price of the bond will be influenced by the floor price and changing interest rates. The stock price needs to rise from $30.00 per share closer to $36.93 ($923.14/ 25) before the bond price will react directly to stock price changes. 19-13. Swift Shoe a. They will probably convert the bonds to common shares. With a conversion ratio of 22 and a common stock price of $59.25, the value of the converted securities would be $1,303.50. This is substantially above the call value of $1,080. Thus, there is a strong inducement to convert. b. Bond price = share price × conversion ratio = $60 × 22 = $1,320 c. Bond price in two months = stock price × conversion ratio = $63.50 × 20 = $1,270 You should convert now rather than hold on to the bonds for two more months. The overall value will be $50 less at that point in time. 19-14. Vernon Glass Company Conversion value Bond price (now) Next year Conversion value Bond price (now) Rate of return = = Share price × conversion ratio = $19 × 50 = $950 = Conversion value + premium = $950 + $70 = $1,020 = Share price × conversion ratio = $25 × 50 = $1,250 = Conversion value + premium = $1,250 + $15 = $1,265 $1,265 − $1,020 $245 = = 0.2402 = 24.02% $1,020 $1,020 19-15. Tulsa Drilling a. First find the price of the convertible bond. The conversion value is $1,280 ($32 × 40). The conversion value, $1,280, plus the $70 premium, equals $1,350, the current market price of the convertible bond. Next, find the price of the convertible bond on this day next year. $42 stock price × 40 shares = $1,680 conversion value $1,680 conversion value + $20 premium = $1,700 market price of the convertible bond ($1,700 – $1,350)/$1,350 = $350/$1,350 = 25.93% annual return. b. Pure bond value after one year (nine years remaining). n = 18 and i = 4% Calculator: PV =? FV = 1,000 %I/Y = 4% (8%/ 2) Compute: PV = $1,189.89 PMT = $55 ($110/2) N = 18 (9 × 2) $55 semiannually × 12.659 (PV IFA ) = $1,000 principal value × .494 (PV IF ) 494.00 $ 696.24 = $1,190.24 Because the pure bond value of $1,189.89 is still well below the conversion value of $1,680 and the market value of $1,700, it would not have a significant effect on valuation. The share price is the major factor determining the convertible bond price. 19-16. Manpower Electric Company Manpower Electric Company has 7 percent convertible bonds outstanding. Each bond has a $1,000 par value. The conversion ratio is 25, the share price is $38, and the bonds mature in 16 years. a. What is the conversion value of a bond? 25 shares × $38 per share = $950 conversion value b. Assume after one year, the common stock price falls to $27.50. What is the conversion value of the bond? 25 shares × $27.50 per share =$687.50 conversion value c. After one year. Pure bond value Calculator: PV =? FV = 1,000 PMT = $35 ($70/2) %I/Y = 5% (10%/ 2) N = 30 (15 × 2) Compute: PV = $769.41 N = 30 (2 × 15) I/Y = 5% (10%/2) PV of annuity = $35 × 15.372 = $538.02 PV of principal payment = $1000 × .231 = $231.00 Pure Bond Value = $769.02 d. Will the conversion value of the bond (part b) or the pure value of the bond (part c) have a stronger influence on its price in the market? For the time being, the pure bond value ($769.41) will have the stronger influence than the share price. The conversion value of $687.50 is $81.91 less than the pure bond value. As the share price gets closer to the parity point ($769.41/25 shares) of $30.78, the shares will start to exert more influence than the pure bond value. 19-17. St. Lawrence Fisheries Ltd. a. Conversion value = 1.40 shares × $12 share price = $16.80 b. Current preferred yield = $2.00/ $31.00 = .065 or 6.5% c. Dividend yield (common) = $0.25/ $12.00 = .0208 or 2.1% d. The potential for capital gain from the conversion feature, if the common shares appreciate in value. e. The dividend yield on the preferred is more attractive because it is higher, is paid before the common dividend and any capital appreciation in the common share price will be reflected in the preferred price. 19-18. Hansen Toy Company a. I = (M – E) × N I = Intrinsic value of a warrant M = Market value of common stock E = Exercise price of a warrant N = Number of shares each warrant entitles the holder to purchase I = ($28 – $22) × 1.5 = $9.00 b. S = W – I S = Speculative premium S W = Warrant price = $12.25 – $9.00 = $3.25 c. The speculative premium should decrease and approach $0 as the expiration date nears. 19-19. Spring Fields a. I = (M – E) × N = ($21 – 17) × 1 = $4 b. S =W–I = $6 – $4 = $2 19-20. Endless Night Ltd. I = (M – E) × N = ($15.75 – $12.00) × 1 = $3.75 S $1.50 W =W–I = W – $3.75 = $5.25 19-21. A Warrant a. I = (M – E) × N = ($12.00 – $14.50) × 1 = – $2.50 or 0 value b. S =W–I = $4.00 – $0 = $4.00 c. I = (M – E) × N = ($21.75 – $14.50) × 1 = $7.25 S $1.00 W Rate of return (share) = =W–I = W – $7.25 = $8.25 $21.75 − $12.00 $9.75 = = 0.8125 = 81.25% $12.00 $12.00 Rate of return (warrant) = $8.25 − $4.00 $4.25 = = 1.0625 = 106.25% $4.00 $4.00 19-22. Slowboat Transportation Corp. I = (M – E) × N = (? – $17.50) × 1 – $2.75 (purchase price) = $0 (Breakeven) M = $20.25 19-23. Another Warrant a. I = (M – E) × N = ($18.00 – $15.00) × 1 = $3.00 b. S =W–I = $5.00 – $3 = $2.00 c. I = (M – E) × N = ($27.00 – $15.00) × 1 = $12.00 S $0.00 W Rate of return (share) = =W–I = W – $12.00 = $12.00 $27.00 − $18.00 $9 = = 0.500 = 50.0% $18.00 $18 Rate of return (warrant) = $12.00 − $5.00 $7 = = 1.40 = 140.0% $5.00 $5 The warrant is leveraged. A movement in the share price will cause the warrant to rise on a smaller initial investment and, therefore, the percentage gain is larger for the warrant than for the shares. 19-24. Manning Investment Company a. I = (M – E) × N = ($60.00 – $36.00) × 2 = $48.00 $48 × 100 warrants $30 × 100 warrants = $4,800 proceeds from sale = $3,000 purchase price Profit = Proceeds from sale – Purchase price = $4,800 – $3,000 = $1,800 b. Rate of return (warrant) = 19-25. $1,800 = 0.60 = 60.0% $3,000 Manning Investment Company (continued) a. I = (M – E) × N = ($50.00 – $36.00) × 2 = $28.00 b. S =W–I = $30.00 – $28.00 = $2.00 c. $3,000 investment/ $50 per share = 60 shares 60 shares × ($60 – $50) = $600 d. Rate of return (share) = $60.00 − $50.00 $10 = = 0.20 = 20.0% $50.00 $50 19-26. Mr. John Hailey a. Warrants available = b. $1,000 = 200 $5 $ 30 – 20 $ 10 × 50 $500 Rate of return (shares) = c. I new price old price gain shares total dollar gain $500 $10 or = 0.500 = 50.0% $1,000 $20 = (M – E) × N = ($30.00 – $18.00) × 1 = $12.00 (0 speculative premium) $12 –5 $7 × 200 $1,400 Rate of return (warrants) = new price of warrant old price of warrant gain warrants total dollar gain $1,400 $7 or = 1.400 = 140.0% $1,000 $5 d. With an $18 exercise price, at a share price of $14.50, the warrant would have a negative intrinsic value of $3.50 (or zero). With a speculative premium of only $3.50, the warrant would be worthless. Under the problem as described, the warrant would be worthless at stock values of $14.50 or less. Note however that if a speculative premium exists the warrant will have value. 19-27. Pancho’s Restaurants Earnings per share (basic) = net income $350,000 = = $3.50 shares outstanding 100,000 For diluted earnings per share: 800 bonds × 25 shares per bond = 20,000 shares 20,000 shares from conversion + 100,000 original shares = 120,000 adjusted shares for computing diluted eps $800,000 × 0.05 coupon rate × [1 – 0.35 (tax rate)] = $26,000 aftertax interest savings upon conversion $350,000 reported earnings + $26,000 aftertax interest savings = $376,000 adjusted earnings for diluted e.p.s. EPS (diluted) = 19-28. adjusted aftertax income $376,000 = = $3.13 shares (outstanding + converted) 120,000 Pancho’s Restaurants (continued) a. The (basic) earnings per share remains the same ($3.50) no matter what interest rate is paid on bonds generally in the marketplace. b. No effect. The answer is still $3.13. 19-29. Meyers Business Systems a. Earnings per share (basic) = $4,000,000 net income = = $2.00 shares outstanding 2,000,000 For diluted earnings per share: Adjusted shares = 2,000,000 + 300,000 + 400,000 = 2,700,000 Aftertax interest savings = ($12,000,000 × 0.09 + $15,000,000 × 0.10) × (1 – 0.50) = $1,290,000 Adjusted earnings aftertax EPS (diluted) = = $4,000,000 + $1,290,000 = $5,290,000 adjusted aftertax income $5,290,000 = = $1.96 shares (outstanding + converted) 2,700,000 b. Adjusted shares = 2,700,000 + warrant adjustment = 2,700,000 + 100,000 – [($20 × 100,000)/ $40] = 2,750,000 Proceeds from exercise of warrants assumed used to repurchase shares at market price. EPS (diluted) = adjusted aftertax income $5,290,000 = = $1.92 shares (outstanding + converted) 2,750,000 Comprehensive Problems 19-30. United Technology Corporation (UTC) Interest expense 11% × $40 million = $4,400,000 Shares from conversion = 30 × 40,000 bonds = 1,200,000 Conversion value = 30 shares × $41 per share = $1,230 Call price = $1,000 × 1.09 = $1,090 a. If the bond is called, it will be converted because the conversion value is greater than the call price ($1,230 > $1,090). (Basic) EPS before conversion: Earnings per share (basic) = net income $38,000,000 = = $6.33 shares outstanding 6,000,000 (Basic)EPS after conversion (diluted eps as well): new aftertax income shares (outstanding + converted) $38,000,000 + $4,400,000 × (1 − 0.25) = = $5.74 6,000,000 + 1,200,000 EPS (diluted) = There is a reduction in basic EPS from $6.33 to $5.74. Diluted EPS after conversion is the same as before conversion because the potential new shares and interest reduction would be already accounted for in diluted EPS. b. With the elimination of the convertible bond, UTC has reduced its debt and increased its equity financing. This provides more flexibility in the way of debt issues for the future. With the current interest rate at 8 percent, UTC could sell a new issue of straight debt and repurchase shares of common stock in the open market. This would serve the purpose of a partial refunding which would result in a lower outlay for interest and dividends. Flexibility is improved. c. Aftertax dividend expense= 1,200,000 × $3.50 = $4,200,000 Aftertax interest expense = $4,400,000 (1 ─ .25) = $3,300,000 Aftertax net cash loss $ 900,000 d. The shareholders will take the 30 shares of common stock since the conversion value of $1,230 is greater than the call price of $1,090. The dividend will also be greater than the interest expense on the old bond or interest that can be earned in the market at current rates of 8 percent. The dividend yield is 8.54 percent ($3.50/$41.00). e. Bonds have a required payment while the dividend has greater risk. However, in this case the dividend yield has become more attractive before tax and tax treatment would further enhance the desirability of the shares. Whether holding the bonds or the shares, capital appreciation will be shared equally. MINI CASE Hamilton Products (Convertibles) This case encourages the student to more fully appreciate the financial characteristics of convertible bonds. It also allows the student to see that the pure bond value is not necessarily stable, but may change because of changing interest rates or business risk. The student not only views upside potential, but increasing downside exposure as well. a. Conversion value = conversion ratio × common share price = 27 × $32.75 = $884.25 Conversion premium = convertible bond price – conversion value = $1,000.00 – $884.25 = $115.75 b. First determine the conversion value: Conversion value = conversion ratio × common share price = 27 × $45.50 = $1,228.50 Then determine the conversion premium: Conversion premium = convertible bond price – conversion value = $1,250.00 – $1,228.50 = $21.50 c. First determine the conversion value: Conversion value = conversion ratio x common share price = 27 × $29.75 = $803.25 Then add the conversion premium: Convertible bond price = Conversion value + conversion premium = $803.25 + $98 = $901.25 d. Pure Bond Value Present value of interest payments PV A = A × PV IFA (n = 17, %I/Y = 10%) = $65 × 8.022 = $521.43 Present value of principal payment (par value) at maturity PV = FV × PV IF (n = 17, %I/Y = 10%) = $1,000 x .198 = $198.00 Present value of interest payments Present value of principal payment Total present value of pure bond Calculator: Compute: PV =? FV = 1,000 %I/Y = 10% N = 17 PV = $719.25 $521.43 198.00 $719.43 PMT = $65 Andre should probably not take too much comfort in the pure bond price. The convertible bond is selling for $901.25 as indicated in question c and the pure bond value is $719.25. That indicates a potential loss of $182 or 20.2% ($182/$901.25). Furthermore, there is always the danger of interest rates on comparable bonds going even higher. Originally, the pure bond value was $853.17, which certainly would have provided more comfort. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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