As an alternative to the bond with warrants, Mr. Duncan is considering convertible bonds. The firm’s investment bankers estimate that EduSoft could sell a 20-year, 8.5% coupon (paid annually), callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 10% coupon (paid annually). The convertibles would be call protected for 5 years, the call price would be $1,100, and the company would probably call the bonds as soon as possible after their conversion value exceeds $1,200. Note, though, that the call must occur on an issue-date anniversary. EduSoft’s current stock price is $20, the dividend is expected to grow at a constant 8% rate. The convertible could be converted into 40 shares of EduSoft stock at owner’s option.

1) What conversion price is built into the bond?

2) What is the convertibles’ straight-debt value? What is the implied value of the convertibility feature?

3) What is the formula for the bond’s expected conversion value in any year? What is its conversion value at Year 0? At Year 10?

4) What is meant by the floor value of a convertible? What is the convertible’s expected floor value at Year 0? At Year 10?

5) Assume that EduSoft intends to force conversion by calling the bond as soon as possible after its conversion value exceeds 20% above its par value, or 1.2($1,000) = $1,200. When is the issue expected to be called? (Hint: Recall that the call must be made on an anniversary date of the issue)

6) What is the expected cost of capital for the convertible to EduSoft? Does this cost appear to be consistent with the riskiness of the issue?

7) What is the after-tax cost of the convertible bond?

Please show ALL work and or formula.