Andre Weather by, an aspiring artist, had just sold his fifth painting of the year and now had $5,000 in cash to invest. His first inclination was to place his money in a CDIC insured savings account, but he was disappointed to find out that his annual return would be less than 2 percent.
Knowing little about investment alternatives, Andre knew he must seek advice from a pro. He recalled that at his ten-year high school reunion he had run into Carol Upshaw, a University of Saskatchewan finance major, who was now a stockbroker with Dominion Securities.
Early Monday morning Andre called Carol and she said she would be able to provide him with help. During the course of their conversation, Andre indicated that he wanted to invest his funds in a stock or bond that provided a good annual return and also hadthe potential to increase in value. Beyond that, he was able to stipulate little else.
Carol considered a number of alternatives, but decided on Hamilton Products. She was particularly interested in the firm's convertible securities, which paid 6.5 percent annual interest and were also convertible in 27 shares of common stock. The bonds had a maturity date 20 years in the future. She explained to Andre that not only would he receive a good annual return, but he could enjoy appreciation in value if the common stock did well.
The bonds were to be issued at a par value of $1,000 on the day that Andre called. The common stock of Hamilton Products was currently selling for $32.75 per share. Straight, nonconvertible bonds of equal risk and maturity to those of Hamilton Products were currently yielding 8 percent. Carol said that because the bonds paid 6.5 percent interest, they should hold up well in value even if the stock did poorly. The initial pure bond price value was $853.17.
Hamilton Products produced hot asphalt and ready-mixed concrete and was located in Vancouver, British Columbia. Plans called for $12 billion for highway and mass transit projects over the next six years. Although the design and approval of new projects was taking longer than expected, by late 2003 competitive bidding on projects was starting and Hamilton Products stood to be a major winner in the process. For this reason Carol thought the firm's share price could well increase in the future.
Andre decided to buy the convertible bonds. Since his expertise was in painting and not investing, he wanted to get back to his main endeavour as quickly as possible.
Fortunately, the stock did well over the next two years, increasing in value to $45.50. The bonds also increased in value to $1,250. It was at this point that Carol called Andre and warned him that a major provincial investigation into highway construction contracts might be undertaken by a subcommittee of the B.C. legislature. She thought Hamilton Products could be a target of the investigation and suggested that he take his profits and look elsewhere for an investment.
However, Andre was now intrigued by his high returns and decided to hold onto his bonds (somewhat to Carol's disappointment). As it turned out, Hamilton Products was found in violation of provincial regulations on a number of major contracts and the share price plummeted to $29.75 per share in the next year. During the same time period, a combination of a downgrading of the firm's credit rating and an increase in interest rates caused the yield on straight, nonconvertible bonds of those of equal risk and maturity to Hamilton Products to go to 10 percent. Hamilton Product's bonds had 17 years remaining to maturity.
Although Andre was disappointed in the drop in the firm's common stock price, he thought he could take some comfort in the fact that the convertible bonds were an interest-paying security, which gave them a basic value below which they normally would not fall.
a. At the time that Andre purchased the bonds, what was the conversion value? What was the conversion premium?
b. When the bonds got up to $1 ,250, what was the conversion premium?
c. Assume there is a conversion premium of $98 when the common stock price fell to $29.75. What is the price of the convertible bond?
d. What is the pure bond value after interest rates have gone up to 10 percent? The yield to maturity (required rate of return) is 10 percent and there are 17 years left to maturity. The bonds are continuing to make annual interest payments of 6.5 percent ($65). The principal payment at maturity is $1 ,000.
e. How much comfort should Andre take in the pure bond value computed in part d?