Question
Consider a firm in a single-period model whose assets are currently worth $10 million. At the end of the period, the assets will be worth
Consider a firm in a single-period model whose assets are currently worth $10 million. At the end of the period, the assets will be worth either $20 million or $5 million. The firm has 1,000 shares of stock outstanding and 100 convertible bonds with a total face value of $6 million. Each bond has a conversion ratio of 10 shares. The bonds mature at the end of the period and the risk-free rate is assumed to be 10%. What is the current value of these bonds? Notice that if the bondholders convert their bonds today, they will receive a conversion value of $5 million (=1/2*$10 million). Therefore, the option to wait and delay making the conversion decision is worth $1.36 million.
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