Two firms have common stock and convertible bonds outstanding. Information concerning these securities is as follows:

Firm A Firm B Common stock Price of common stock $46 $30 Cash dividend none $1 Convertible bond Principal $1,000 $1,000 Conversion price $50

(20 shares)

$331⁄3

(30 shares)

Maturity 10 years 10 years Coupon 7.5% 7.5%

Market price $1,100 $1,100

a) What is the value of each bond in terms of stock?

b) What is the premium paid over each bond’s value as stock?

c) What is each bond’s income advantage over the stock into which the bond may be converted?

d) How long will it take for the income advantage to offset the premium determined in part (b)?

e) If after four years firm A’s stock sells for $65 and the firm calls the bond, what is the holding period return and the annual rate of return earned on an investment in the stock or in the bond? (You may wish to review the material on calculating rates of return presented in Chapter 10.)