Question
Great Car Company Limited, through its subsidiaries, manufactures and sells pick-up trucks in Asia market under branded names. The Company also researches, develops, and manufactures
Great Car Company Limited, through its subsidiaries, manufactures and sells pick-up trucks in Asia market under branded names. The Company also researches, develops, and manufactures principal automotive components for use in the assembly of pick-up trucks. The company is considering a new investment project which has the same risk as existing businesses. The initial outlay for the project is $55 million. The company expects that the project will generate additional earnings of $10 million per year. The company currently has no debt. The current annual earnings available to common stockholders are $80 million. The company currently has 6 million shares outstanding. Currently, the required rate of return on equity is 12%. Traditionally, the company has paid out all earnings to the stockholders as dividends and financed capital expenditures with new issues of common stock. All earning streams are assumed to be perpetuities. There are no taxes and no bankruptcy costs.
(a) Analyze the value of the firm if common stock is issued to finance the project.
(b) One of the banks suggests that the company can issue $55 million, 9% perpetual bonds to finance the project. Advise the value of the company and the rate of return required by stockholders.
(c) TSL, another competitor firm, has a 8% coupon rate convertible bond due 20 years from now. The convertible bond has a par value of $1,000 and is selling at $970. The conversion price of the bond is $50 per share. A non-convertible coupon bond of similar quality is currently yielding 10%. The common stock of TSL is selling at $40 per share. Assume that bond interest payments are made annually.
Ci Determine the conversion ratio of the convertible bond.
Cii Calculate the conversion premium of the convertible bond.
C iii Access the minimum price at which the convertible bond should sell.
C iv Explain why a convertible bond sells at a premium above its value as a bond or common stock.
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