Chapter 19

Discussion Questions
19-1. These are all derivatives that have value based to a large extent on the value of an underlying asset. All are used to reduce risk (hedge) or to take on risk (speculate). Forwards are customized contracts (as to the amount and future delivery (exercise) date) between two parties for the future delivery of any asset. These contracts almost always must be exercised. Futures are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange. Options are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange. The holder can also let them expire if they have no further use, unlike forwards or futures. 19-2. A firm may force conversion of a bond issue through the use of the call privilege. If a bond has had a substantial gain in value due to an increase in price of the underlying common stock, the bondholder may prefer to convert to common stock rather than trade in the bond at some small premium over par as stipulated in a call agreement. 19-3. The advantages to the corporation of a convertible security are: a. The interest rate is lower than on a straight issue. b. This type of security may be the only device for allowing a small firm access to the capital markets. c. The convertible allows the firm to effectively sell stock at a higher price than that possible when the bond was initially issued (but perhaps at a lower price than future price potential might provide). 19-4. Basic earnings per share considers none of the potentially dilutive effects of convertibles, warrants, and other securities that can generate new shares of common stock. Fully diluted earnings per share considers all dilutive effects regardless of their origin. Adjustment includes: a. Numerator adjustment includes dividends payable on convertible preferred shares, aftertax interest on convertible debt and inputed aftertax interest earned on cash that would have been received from rights, warrants, and options if they had been exercised. b. Denominator includes all common shares outstanding and equivalent shares of all convertible preferreds and bonds and common shares issued if rights, warrants and options exercised.

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19-5. Investors are willing to pay a premium over the theoretical value for a convertible preferred share issue because of the future prospects for the associated common stock. Thus, if there are many years remaining for the conversion privilege, the investor will be able to receive a reasonably high dividend rate and still have the existing option of going to common stock if circumstances justify. 19-6. The floor price of a convertible is based on the pure bond value associated with the interest payments on the bond as shown in Figure 19-1. Regardless of how low the associated common stock might go, the semiannual interest payments will set a floor price for the bond. For convertible preferreds, the guaranteed dividend payment does the same thing. 19-7. a. The strength of the underlying securities that can be substituted for the convertible. b. A decrease in long-term yields would primarily affect convertible securities trading on the strength of the dividend or interest yield, compared to securities trading on the common share value. 19-8. A "step-up" in conversion price means the conversion price will increase with the passage of time and likewise the conversion ratio will decline. Before each step-up, there is an inducement for bondholders to convert to common at the more desirable price. 19-9. To determine fully diluted earnings per share when convertibles are present, we add aftertax savings from the reduced interest or dividend obligation on assumed conversion to normally computed earnings aftertaxes. For example, if $450,000 in interest could be saved on an assumed conversion of bonds to 100,000 common shares, we would add $270,000 to the numerator (assuming a 40 percent tax rate) and 100,000 into the denominator. For warrants, we must compute the number of new shares that could be created by the exercise of all outstanding warrants and compute the return expected on the proceeds received from the exercise of the warrants. 19-10. Convertible bonds and warrants are similar in that they give the security holder a future option on the common stock of the corporation. They are dissimilar in that a convertible bond represents a debt obligation of the firm as well. When it is converted to common stock, corporate debt will actually be reduced and the capitalization of the firm will not increase. A warrant is different in that it is not a valuable instrument on its own merits, and also its exercise will increase the overall capitalization of the firm. 19-11. Warrants may be used to sweeten a debt offering or as part of a merger offer or a bankruptcy proceeding. 19-12. Warrants may sell above their intrinsic value because the investor views the associated stock's prospects as being bright, or because there is a reasonable amount of time to run before the warrant expires. Warrants also allow for the use of leveraged investing. 19-13. The speculative premium will be larger the longer the time to maturity, the higher the time value of money (a warrant is more valuable as only a downpayment), the greater the
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volatility of the underlying security (a greater chance of gain) and the closer the exercise price is to the market price of the underlying security (the greatest leverage opportunity). Dividends on the underlying security will dampen the speculative premium. 19-14. Put warrants go up in value as the underlying security decreases in value. Financial intermediaries have at various times offered these securities.

Internet Resources and Questions

1. 2. 3. 4. 5. 6. http://www.globeandmail.com/businessPE (Money and markets; foreign exchange) www.cbot.com (see problem #2 for format) www.cbot.com (see problem #3 for format) www.nymex.com (see problem # 3 for format) www.tsx.ca www.me.org (see problem #4 for format) www.tsx,ca www.me.org (see problem #4 for format)

Problems 19-1. Giffen Forest Products The forward rate will produce $ Canadian = 155,000 2.2356 = $346,518 No payment is required today, only at the forward date. Forwards are usually executed through financial institutions, usually banks. They may require a good faith deposit or appropriate security to insure the completion of the contract.

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19-2. Western Farmer a. Canola price ($ Cdn. / tonne) $370 $334 370 $(36) $334,000 Cash received 1,000 tonnes $300,000 $334,000 300,000 $ 34,000 Cash received 1,000 tonnes $370,000 $334,000 370,000 $(36,000)

In November Sell canola at: Cash (spot) rate Close out future: Future (Nov. expiry) Sold at (March) Purchase at (Nov.) Loss on future Total revenues with: Cash market and future b.

Canola price ($ Cdn. / tonne) $300 $334 300 $ 34 $334,000

In November Sell canola at: Cash (spot) rate Close out future: Future (Nov. expiry) Sold at (March) Purchase at (Nov.) Gain on future Total revenues with: Cash market and future

Regardless of price movement up or down you, the farmer, have locked in a price of $334,000. Your risk is reduced and you can plan based on this expected receipt for your canola. There will be some differences in practice as the future price and cash prices are rarely identical as in this example.

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19-3. a.

Jewelry Manufacturer Gold price ($ U.S. / ounce) $350 $350 292 $ 58 $146,000 Cash payment 500 ounces $125,000 $125,000 146,000 $21,000 Cash payment 500 ounces $175,000 $175,000 146,000 $ 29,000

In August Purchase gold at: Cash (spot) rate Close out future: Future (August expiry) Sold at (August) Purchase at (March) Gain on future Total payment with: Cash market and future b.

In August Purchase gold at: Cash (spot) rate Close out future: Future (August expiry) Sold at (August) Purchase at (March) Loss on future Total payment with: Cash market and future

Gold price ($ U.S. / ounce) $250 $250 292 $ 42 $146,000

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19-4. July 2002 Options a. Calls

1 Share Price

2 Strike Price $50.00 45.00 8.00 40.00 2 Strike Price $50.00 45.00 8.00 40.00

Celestica iUnits 60 Nortel PetroCanada

$58.85 45.10 8.01 39.87 1 Share Price $58.85 45.10 8.01 39.87

3 Intrinsic Value (1 2) $8.85 0.10 0.01 0.00 3 Intrinsic Value (2 1) $0.00 0.00 0.00 0.13

4 Call Option Price $13.30 2.40 1.70 2.85 4 Put Option Price $2.95 2.30 1.50 2.70

5 Speculative Premium (4 3) $4.45 2.30 1.69 2.85 5 Speculative Premium (4 3) $2.95 2.30 1.50 2.57

b. Puts

Celestica iUnits 60 Nortel PetroCanada

c. Celestica

Share price = $70.00

Strike price = $50.00

Call option price Put option price

= Intrinsic value + speculative premium = ($70 $50) + $0.50 = $20.50 = Intrinsic value + speculative premium = ($50 $70) + $0.50 = $0.00 + $0.50 = $0.50 Strike price = $50.00

d. Celestica

Share price = $45.00

Call option price Put option price

= Intrinsic value + speculative premium = ($45 $50) + $1.25 = $0.00 + $1.25 = $1.25 = Intrinsic value + speculative premium = ($50 $45) + $1.25 = $5.00 + $1.25 = $6.25

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19-5.

Plunkett Gym Equipment, Inc. a. $34.75 stock price 25 shares = $868.75 conversion value b. $960.00 bond price $868.75 conversion value = $91.25 conversion premium c. $1,000 par value/ 25 conversion ratio = $40 conversion price

19-6.

Goldman Sack Company

First compute the conversion ratio. The conversion ratio is equal to the par value the conversion price:

Par value/ conversion price $1,000/ $40

= conversion ratio = 25 conversion ratio

Multiply the common stock price times the conversion ratio to get the conversion value:

Common stock price conversion ratio = conversion value $42.00 25 shares = $1,050 conversion value
Add the conversion premium to the conversion value to arrive at the convertible bond price:

Conversion Value + Conversion Premium = Convertible Bond Price = $1050 + $55 = $1,105 convertible bond price 19-7. a. Red Deer Packers $1,000 par value/ $20 conversion price = 50 shares conversion ratio $12 common stock price 50 shares = $600 conversion value $850 bond price $600 = $250 conversion premium b. $850 bond price/ 50 shares = $17

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19-8. a.

Hughes Technology Par value/ conversion price $1,000/ $50 = conversion ratio = 20

20 shares $41 common stock price = $820 conversion value b. Pure bond value: Calculator: Compute: PV =? FV = 1,000 %i = 3.5% (7%/ 2) PV = $765.44 PMT = $25 ($50/2) N = 50 (25 2)

19-9. Pure bond value: Calculator: Compute:

Hughes Revisited PV =? FV = 1,000 %i = 4.5% (9%/ 2) PV = $604.76 PMT = $25 ($50/2) N = 50 (25 2)

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19-10.

Western Pipeline, Inc.

a. $43.50 stock price 28 shares = $1,218 conversion value + 10 conversion premium $1,228 Bond price b. 5% $1,000 = $50 Annual interest Current yield = c. Calculator: ($50/2) Compute: Annual interest $50 = = 0.0407 = 4.07% Bond price $1,228 PV =$1,228 FV = 1,000 PMT = $25

%i =? N = 14 (7 2) %i = 0.775 2 = 1.55% (annual) conversion value conversion premium Bond price PMT = $25

d. $22 stock price 28 shares = $ 630 + 100 $ 730 Calculator: ($50/2) Compute: PV =$730

FV = 1,000

%i =? N = 14 (7 2) %i = 5.27 2 = 10.55% (annual)

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19-11.

Eastern Digital Corporation

a. $1,000 par value/ 40 conversion ratio = $25 conversion price b. $18.25 stock price 40 conversion ratio = $730 conversion value c. Pure bond value: Calculator: PV =? FV= 1,000 %i = 5% (10%/2) Compute: PV = $914.20 d.
2000 1800

PMT = $45 ($90/2) N = 40 (20 2)

1600

1400

Floor value

1000

800

Conversion value

600

400

200

0 0 10 20 30 40 50 Price of common shares

e. Most likely, the price of the bond will be influenced by the floor price and changing interest rates. The stock price needs to rise from $18.26 per share closer to $22.86 ($914.20/ 40) before the bond price will react directly to stock price changes.

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Bond values

Pure bond value

$914.20

1200

19-12.

Defense Systems, Inc.

conversion ratio of 33 and a common stock price of $39.25, the value of the converted securities would be $1,295.25. This is substantially above the call value of $1,070. Thus, there is a strong inducement to convert.

a. They will probably convert the bonds to common shares. With a

b. Bond price

= share price conversion ratio = $40 33 = $1,320 = stock price conversion ratio = $42.50 30 = $1,275

c. Bond price in two months

You should convert now rather than hold on to the bonds for two more months. The overall value will be $45 less at that point in time.

19-13.

Red Cliff Glass Company Conversion value Bond price (now) Next year Conversion value Bond price (now) Rate of return = = Share price conversion ratio = $7 125 = $875 = Conversion value + premium = $875 + $75 = $950 = Share price conversion ratio = $10 125 = $1,250 = Conversion value + premium = $1,250 + $20 = $1,270

$1,270 $950 $320 = = 0.3368 = 33.68% $950 950

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19-14. a. Conversion value

B.C. Fisheries Ltd. = 1.25 shares $24 share price = $30 = $2.00/ $31.00 = .065 or 6.5% = $0.60/ $24.00 = .025 or 2.5%

b. Current preferred yield c. Dividend yield (common)

d. The potential for capital gain from the conversion feature, if the common
shares appreciate in value.

e. The dividend yield on the preferred is more attractive because it is higher,

is paid before the common dividend and any capital appreciation in the common share price will be reflected in the preferred price.

19-15. a. I = (M E) N

Wilton Cheese Co.

I = Intrinsic value of a warrant M = Market value of common stock E = Exercise price of a warrant N = Number of shares each warrant entitles the holder to purchase I = ($13 $10) 1.5 = $4.50 W = Warrant price b. S = W I S = Speculative premium S = $8.25 $4.50 = $3.75 c. The speculative premium should decrease and approach $0 as the
expiration date nears.

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19-16. a. I

Labrador Fields = (M E) N = ($25 15) 1 = $10 =WI = $12 $10 = $2

b. S

19-17. I

Sleepless Night Ltd. = (M E) N = ($16.25 $10.00) 1 = $6.25 =WI = W $6.25 = $9.25

S $3.00 W

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19-18. a. I

A Warrant = (M E) N = ($10.00 $12.50) 1 = $2.50 or 0 value =WI = $3.25 $0 = $3.25 = (M E) N = ($22.50 $12.50) 1 = $10.00 =WI = W $10.00 = $10.75

b.

c.

S $0.75 W

Rate of return (share) =

$22.50 $12.50 $10 = = 0.800 = 80.0% $12.50 $12.50 $10.75 $3.25 $7.50 = = 2.308 = 231.0% $3.25 $3.25

Rate of return (warrant) =

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19-19. a. I

Another Warrant = (M E) N = ($16.00 $14.00) 1 = $2.00 =WI = $5.00 $2 = $3.00 = (M E) N = ($24.00 $14.00) 1 = $10.00 =WI = W $10.00 = $10.00

b.

c.

S $0.00 W

Rate of return (share) =

$24.00 $16.00 $8 = = 0.500 = 50.0% $16.00 $16 $10.00 $5.00 $5 = = 1.00 = 100.0% $5.00 $5

Rate of return (warrant) =

The warrant is leveraged. A movement in the stock price will cause the warrant to rise on a smaller initial investment and, therefore, the percentage gain is larger for the warrant than for the stock.

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19-20. a.

Redford Investment Company I = (M E) N = ($50.00 $30.00) 2 = $40.00 = $4,000 proceeds from sale = $2,400 purchase price = Proceeds from sale Purchase price = $4,000 $2,400 = $1,600 $1,600 = 0.6667 = 66.67% $2,400

$40 100 warrants $24 100 warrants Profit

b. Rate of return (warrant) =

19-21. a.

Redford Investment Company (continued) I = (M E) N = ($40.00 $30.00) 2 = $20.00 =WI = $24.00 $20.00 = $4.00

b.

c. $2,400 investment/ $40 per share = 60 shares 60 shares ($50 $40) = $600 d. Rate of return (share) = $50.00 $40.00 $10 = = 0.250 = 25.0% $40.00 $40

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19-22.

Mr. Harvey Cunningham $1,200 = 200 $6 new price old price gain shares total dollar gain

a. Warrants available = b.

$ 35 25 $ 10 48 $480

Rate of return (shares) = c. I

$480 $10 or = 0.400 = 40.0% $1,200 $25

= (M E) N = ($35.00 $23.00) 1 = $12.00 (0 speculative premium) $12 6 $6 200 $1,200 new price of warrant old price of warrant gain warrants total dollar gain $1,200 $6 or = 1.000 = 100.0% $1,200 $6

Rate of return (warrants) =

d. With a $23 exercise price, at a share price of $19, the warrant would have a negative intrinsic value of $4 (or zero). With a speculative premium of only $4.00, the warrant would be worthless. Under the problem as described, the warrant would be worthless at stock values of $19 or less.

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19-23.

Hughes Technology net income $450,000 = = $4.50 shares outstanding 100,000

Earnings per share (basic) =

For fully diluted earnings per share: 1,200 bonds 20 shares per bond = 24,000 shares 24,000 shares from conversion + 100,000 original shares = 124,000 adjusted shares for computing fully diluted $1,200,000 0.06 coupon rate [1 0.34 (tax rate)] = $47,520 aftertax interest savings upon conversion $450,000 reported earnings + $47,520 aftertax interest savings = $497,520 adjusted earnings for fully diluted e.p.s. EPS (fully diluted) = adjusted aftertax income $497,520 = = $4.01 fully diluted shares 124,000

19-24.

Hughes Technology (continued)

a. The basic (unadjusted) earnings per share remains the same ($4.50) no matter what interest rate is paid on bonds generally in the marketplace. b. No effect. The answer is still $4.01.

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19-25. a.

Meyers Business Systems net income $4,000,000 = = $2.00 shares outstanding 2,000,000

Earnings per share (basic) =

For fully diluted earnings per share: Adjusted shares = 2,000,000 + 300,000 + 400,000 = 2,700,000

Aftertax interest savings = ($12,000,000 0.09 + $15,000,000 0.10) (1 0.50) = $1,290,000 Adjusted earnings aftertax = $4,000,000 + $1,290,000 = $5,290,000

EPS (fully diluted) =

adjusted aftertax income $5,290,000 = = $1.96 fully diluted shares 2,700,000

$40]

b. Adjusted shares = 2,700,000 + warrant adjustment = 2,700,000 + 100,000 [($20 100,000)/ = 2,750,000 Proceeds from exercise of warrants assumed used to repurchase shares at market price.

EPS (fully diluted) =

adjusted aftertax income $5,290,000 = = $1.92 fully diluted shares 2,750,000

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Comprehensive Problems 19-26. I.M. Stein, Inc. (IMS) Interest expense 10% $30 million = $3,000,000 million Shares created from conversion = 25 30,000 bonds = 750,000 Conversion value = 25 shares $48 per share = $1,200 Call price = $1,000 1.10 = $1,100 a. If the bond is called, it will be converted because the conversion value is greater than the call price ($1,230 > $1,090). Basic EPS before conversion: Earnings per share (basic) = net income $42,000,000 = = $8.40 shares outstanding 5,000,000

Basic (unadjusted) EPS after conversion (diluted eps as well): new aftertax income fully diluted shares $42,000,000 + $3,000,000 (1 0.40) = = $7.62 5,000,000 + 750,000 EPS (fully diluted) =
There is a reduction in basic EPS from $8.40 to $7.62. Fully diluted EPS after conversion is the same as before conversion because the potential new shares and interest reduction would be already accounted for in fully diluted EPS.

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b. With the elimination of the convertible bond, IMS has reduced its debt and increased its equity financing. This provides more flexibility in the way of debt issues for the future. With the current interest rate at 8 percent, IMS could sell a new issue of straight debt and repurchase shares of common stock in the open market. This would serve the purpose of a partial refunding which would result in a lower outlay for interest and dividends. Flexibility is improved. c. Aftertax dividend expense= 750,000 $4.00 = $3,000,000 Aftertax interest expense = $3,000,000 (1 .40) = $1,800,000 Aftertax net cash loss $1,200,000 d. The shareholders will take the 30 shares of common stock since the conversion value of $1,200 is greater than the call price of $1,100. The dividend will also be greater than the interest expense on the old bond or interest that can be earned in the market at current rates of 8 percent. The dividend yield is 8.16 percent ($4.00/$49.00). e. Bonds have a required payment while the dividend has greater risk. However, in this case the dividend yield has become more attractive before tax and tax treatment would further enhance the desirability of the shares. Whether holding the bonds or the shares, capital appreciation will be shared equally.

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19-27.

Andre Weatherby
This case encourages the student to more fully appreciate the financial characteristics of convertible bonds. It also allows the student to see that the pure bond value is not necessarily stable, but may change because of changing interest rates or business risk. The student not only views upside potential, but increasing downside exposure as well.

a. Conversion value

= conversion ratio common share price = 27 $32.75 = $884.25

Conversion premium = convertible bond price conversion value = $1,000.00 $884.25 = $115.75 b. First determine the conversion value: Conversion value = conversion ratio common share price = 27 $45.50 = $1,228.50 Then determine the conversion premium: Conversion premium = convertible bond price conversion value = $1,250.00 $1,228.50 = $21.50 c. First determine the conversion value: Conversion value = conversion ratio x common share price = 27 $29.75 = $803.25 Then add the conversion premium: Convertible bond price = Conversion value + conversion premium = $803.25 + $98 = $901.25

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d. Pure Bond Value Present value of interest payments PVA = A PVIFA (n = 17, %i = 10%) = $65 8.022 = $521.43 Present value of principal payment (par value) at maturity PV = FV PVIF (n = 17, %i = 10%) = $1,000 x .198 = $198.00 Present value of interest payments Present value of principal payment Total present value of pure bond Calculator: Compute: PV =? FV = 1,000 %i = 10% N = 17 PV = $719.25 $521.43 198.00 $719.43 PMT = $65

Andre should probably not take too much comfort in the pure bond price. The convertible bond is selling for $901.25 as indicated in question c and the pure bond value is $719.25. That indicates a potential loss of $182 or 20.2% ($182/$901.25). Furthermore, there is always the danger of interest rates on comparable bonds going even higher. Originally, the pure bond value was $853.17, which certainly would have provided more comfort.

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