Consider a 4% coupon, $1000 par value, and 15 years in maturity, and is sold for $1000. It is callable after 7 years. The bond is a convertible bond allowing the investor to exchange the bond for 40 shares of common stock in the future. The current stock price is $20. The stock has a dividend yield of 2% and growth of 5% per year. If you need the current rate of interest, it is 6%.

If the company decides to call back the bond, and give you $1040, what would you do? Take $1040, or convert the bond? Show your calculations to prove your answer.

Year = 0 $35 X 18 = $630

Year = 5 $35 (1 + 0.09) ^5 X 18 = $969

Year = 10 $35 )1 + 0.09)^10 X 18 = $1,491

At this time, the bond is callable at $1050. Thus, investors will convert on the 10^th year if the convertible bond is called. As a result, the mix of debt and equity in the capital structure will change: bonds decrease and stock will increase.