(19–7)

Niendorf Incorporated needs to raise $25 million to construct production facilities for a new type of USB memory device. The firm’s straight nonconvertible debentures currently yield 9%. Its stock sells for $23 per share, has an expected constant growth rate of 6%, and has an expected dividend yield of 7%, for a total expected return on equity of 13%. Investment bankers have tentatively proposed that the firm raise the $25 million by issuing convertible debentures. These convertibles would have a $1,000 par value, carry a coupon rate of 8%, have a 20-year maturity, and be convertible into 35 shares of stock. Coupon payments would be made annually. The bonds would be noncallable for 5 years, after which they would be callable at a price of $1,075; this call price would decline by $5 per year in Year 6 and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Also assume that management would call eligible bonds if the conversion value exceeded 20% of par value (not 20% of call price).

a. At what year do you expect the bonds will be forced into conversion with a call? What is the bond’s value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because the conversion occurs immediately after the coupon is paid.)

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b. What is the expected rate of return (i.e., the before-tax component cost) on the proposed convertible issue?