Rich McDonald, CFA, is evaluating his investment alternatives in Ytel Incorporated by analyzing a Ytel convertible bond and Ytel common equity. Characteristics of the two securities a re gi ven in the follo wing e xhibit:

Characteristics Convertible Bond Common Equity Par value $1,000 —

Coupon (annual payment) 4% —

Current market price $980 $35 per share Straight bond value $925 —

Conversion ratio 25 —

Conversion option At any time —

Dividend — $0 Expected market price in 1 year $1,125 $45 per share

a. Calculate, based on the exhibit, the i. Current market conversion price for the Ytel convertible bond.

ii. Expected one-year rate of return for the Ytel convertible bond.

iii. Expected one-year rate of return for the Ytel common equity.

One year has passed and Ytel’s common equity price has increased to $51 per share.

Also, over the year, the yield to maturity on Ytel’s nonconvertible bonds of the same maturity increased, while credit spreads remained unchanged.

b. Name the two components of the convertible bond’s value. Indicate whether the value of each component should decrease, stay the same, or increase in response to the i. Increase in Ytel’s common equity price.

ii. Increase in bond yield.

 LO.1