25 7650 8 shares after the warrant issue note that the

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Unformatted text preview: interest rates decreases the straight value component of the convertible bond. Conversely, an increase in interest rates increases the value of the equity call option. Generally, the effect on the straight bond value will be much greater, so we would expect the bond value to fall, although not as much as the decrease in a comparable straight bond. When warrants are exercised the number of shares outstanding increases. This results in the value of the firm being spread out over a larger number of shares, often leading to a decrease in value of each individual share. The decrease in the per-share price of a company’s stock due to a greater number of shares outstanding is known as dilution. In an efficient capital market the difference between the market value of a convertible bond and the value of straight bond is the fair price investors pay for the call option that the convertible or the warrant provides. 5. 6. CHAPTER 24 B-479 7. 8. 9. There are three potential reasons: 1) To match cash flows, that is, they issue securities whose cash flows match those of the firm. 2) To bypass assessing the risk of the company (risk synergy). For example, the risk of company start-ups is hard to evaluate. 3) To reduce agency costs associated with raising money by providing a package that reduces bondholder-stockholder conflicts. Because the holder of the convertible has the option to wait and perhaps do better than what is implied by current stock prices. Theoretically conversion should be forced as soon as the conversion value reaches the call price because other conversion policies will reduce shareholder value. If conversion is forced when conversion values are above the call price, bondholders will be allowed to exchange less valuable bonds for more valuable common stock. In the opposite situation, shareholders are giving bondholders the excess value. 10. No, the market price of the warrant will not equal zero. Since there is a chance that the market price of the stock will rise above the $31 per share exercise price before expiration, the warrant still has some value. Its market price will be greater than zero. As a practical matter, warrants that are far outof-the-money may sell at 0, due to transaction costs. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. The conversion price is the par value divided by the conversion ratio, or: Conversion price = $1,000 / 18.4 Conversion price = $54.35 2. The conversion ratio is the par value divided by the conversion price, or: Conversion ratio = $1,000 / $70.26 Conversion ratio = 14.23 3. First, we need to find the conversion price, which is the par value divided by the conversion ratio, or: Conversion price = $1,000 / 12.80 Conversion price = $78.13 The conversion premium is the necessary increase in stock price to make the bond convertible. So, the conversion premium is: Conversion premium = ($78.13 – 61.18) /$61.18 Conversion premium = 0.2770 or 27.70% 479 CHAPTER 24 B-480 4. a. The conversion ratio is defined as the number of shares that will be issued upon conversion. Since each bond is convertible into 18.50 shares of Hannon’s common stock, the conversion ratio of the convertible bonds is 18.50. The conversion price is defined as the face amount of a convertible bond that the holder must surrender in order to receive a single share. Since the conversion ratio indicates that each bond is convertible into 18.50 shares, the conversion price is: Conversion price = $1,000 / 18.50 Conversion price = $54.05 b. c. The conversion premium is defined as the percentage difference between the conversion price of the convertible bonds and the current stock price. So, the conversion premium is: Conversion premium = ($54.05 – 38.20) /$38.20 Conversion premium = 0.4150 or 41.50% d. The conversion value is defined as the amount that each convertible bond would be worth if it were immediately converted into common stock. So, the conversion value is: Conversion value =$38.20(18.50) Conversion value = $706.70 ,e If the stock price increases by $2, the new conversion value will be: Conversion value =$40.20(18.50) Conversion value = $743.70 5. The total exercise price of each warrant is shares each warrant can purchase times the exercise price, which in this case will be: Exercise price = 3($41) Exercise price = $123 Since the shares of stock are selling at $47, the value of three shares is: Value of shares = 3($47) Value of shares = $141 Therefore, the warrant effectively gives its owner the right to buy $141 worth of stock for $123. It follows that the minimum value of the warrant is the difference between these numbers, or: Minimum warrant value = $141 – 123 Minimum warrant value = $18 If the warrant were selling for less than $18, an investor could earn an arbitrage...
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