Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firm's founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital.

Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firm's B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds.

As Duncan's assistant, you have been asked to help in the decision process by answering the following questions.

(1) Because the presence of warrants results in a lower coupon rate on the accompanying debt issue, shouldn't all debt be issued with warrants? To answer this, estimate the anticipated stock price in 10 years when the warrants are expected to be exercised, and then estimate the return to the holders of the bond-with-warrants packages. Use the corporate valuation model to estimate the expected stock price in 10 years. Assume that EduSoft's current value of operations is $500 million and it is expected to grow at 8% per year.

(2)How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock (which is 13.4%)?

(3) If the corporate tax rate is 25%, what is the after-tax cost of the bond with warrants?