Company executives face a dilemma. They seek new capital to fund expansion initiatives. Common shares are expected to continue to rise sharply in market price, but this would not be the time to issue new stock. Yet interest rates are also high relative to historical interest rates, and the Company currently holds a lowly B bond rating. A debt issue would be quite costly. Would it be feasible to issue either

a) Bonds with warrants, or

b) Convertible bonds ?

Address the following:

1) Explain the difference between warrants and bonds. This means you have to explain both terms. (2 points)

2) One possibility is to issue a bond with warrants. The current stock price is $20. A 20 year annual coupon bond without warrants would require 10% interest. Suppose 45 warrants were attached to the bond, each with an exercise price of $25, to each $1000 bond. Suppose also each warrant could be separated and traded individually at a value of $3

a. What coupon rate should be set on the bond with warrants if the total package is to sell at par (that is, $1000). (2 points)

b. Suppose the bonds were issued and the warrants immediately traded on the open market for $5 each what would that imply about the terms of the issue? Did the company win or lose on their issue? Why do you say this? (2 points)

c. When would you expect the warrants to be exercised? Assume the warrants have a 10 year life- the expire ten years after issue. (2 points)

d. Will the warrants bring in additional capital when exercised? If so how much and what type of capital? (2 points)

3) Consider this alternative: What if convertible bonds are issued? Suppose a 20 year 8.5% annual coupon, callable bond is issued for the face value of $1000 whereas a straight debt issue would require a 10% coupon. The convertible bonds would be call protected for 5 years, the call price would be $1100, and the company would probably call the bonds as soon as possible after the conversion value exceeds $1200. Note though the call would be on an issue date anniversary. The current stock price is $20, the last dividend was $1 and the dividend is expected to grow at a constant 8% rate. Each convertible bond would convert into 40 common shares at the owners option.

a. What conversion price is built into this bond? (2 points)

b. What is the convertibles straight debt value? What is the implied value of the convertibility feature? (2 points)

c. What is the bonds expected conversion value at year 0, and at year 10? (2 points)

d. What is the expected cost of capital for the convertible to this company? Is this cost consistent with the riskiness of the issue? (2 points)

4) How do these convertible bonds help reduce agency costs? (2 points)

Ensure that you properly reference your work where required.