Maggie's Magazines

$($

MM

$)$

$$has straight nonconvertible bond that currently yield

$7$

$\%$

$.$

$$MM

$\text{'}$

s stock sells for $

$2$

$2$

$$per share, has an expected constant growth rate of

$7$

$\%$

$,$

$$and has a dividend yield of

$4$

$

$.$

$$MM plans on issuing convertible bonds that will have a $

$1$

$,$

$0$

$0$

$0$

$$par value, a coupon rate of

$8$

$\%$

$,$

$$a

$2$

$0$

$-$

year maturity, and a conversion ratio of

$3$

$2$

$($

i

$.$

e

$.$

$,$

$$each bond could be convertible into

$3$

$2$

$$shares of stock

$)$

$.$

$$Coupon payments will be made annually. The bonds will be noncallable for

$5$

$$years$,$ after which they will be callable at a price of $

$1$

$,$

$0$

$9$

$0$

; this call price would decline by $

$6$

$$per year in Year

$6$

$$and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Management will call the bonds when the bonds

$$

$$conversion value exceeds

$2$

$5$

$\%$

$$of the bonds

$$

$$par value

$($

not their call price

$)$

$.$

a

$.$

$$For each year, calculate:

$($

$1$

$)$

$$the anticipated stock price;

$($

$2$

$)$

$$the anticipated conversion value;

$($

$3$

$)$

$$the anticipated straight

$-$

bond price; and

$($

$4$

$)$

$$the cash flow to the investor assuming conversion occurs. At what year do you expect the bonds will be forced into conversion with a call? What is the bond

$$

s value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time

$($

Hint: the cash flow includes the conversion value and the coupon payment, because the conversion is immediately after the coupon is paid.

$)$

$$b

$.$

$$What is the expected rate of return

$($

i

$.$

e

$.$

$,$

$$before

$-$

tax component cost

$)$

$$on the proposed convertible issue? c

$.$

$$ Assume that the convertible bondholders require a

$9$

$\%$

$$rate of return. If the coupon rate remains unchanged, then what conversion ratio will give a bond price of $

$1$

$0$

$0$

$0$

$?$