Nullcom, Inc., has debentures (face value ¼ $1,000) outstanding that are convertible into common stock at a price of $40 per share. The debentures pay an interest rate of 9 percent per annum and have a remaining life of 10 years. Nonconvertible debentures of a similar credit rating and maturity are selling at a price to yield 11 percent. The current price of a share of Nullcom's stock is $35.
a. Compute the straight bond value of each of these debentures.
b. Compute the conversion value of each of these debentures.
c. What is the absolute minimum price for one of these debentures today? What price would you expect to pay for one of these debentures?
d. If the debentures are called at 105 today and you own 10 of these debentures, what action should you take?
¦ Nonhedging strategies that managers use to control risk include the acquisition of additional information; diversification; the purchase of insurance; the use of patents, copyrights, and other forms of legal protection of intellectual property; and the limited use of firm-specific assets.
¦ A hedge is a transaction that limits the risk associated with fluctuations in the price of a commodity, currency, or financial instrument. A hedge is accomplished by taking offsetting positions in the ownership of an asset or security through the use of derivative securities, such as forward contracts, futures contracts, and options.
¦ A forward contract is an agreement to buy or sell an asset at some point in time in the future at a price agreed to at the time the forward contract is purchased or sold. Forward contracts can be executed for any quantity of any asset for any maturity date. Consequently, they are not highly liquid. Forward contracts frequently have an element of performance risk from the counterparty to the contract.
¦ A futures contract is a standardized contract, traded on an organized exchange, to buy or sell an asset at a specified future time at a specified price. Because it is standardized with respect to quantity, quality, and delivery date and place, futures contracts are highly liquid. Exchange procedures eliminate performance risk from the counterparty to the contract.
¦ A long hedge involves the purchase of a forward or futures contract to cover required future purchases of a commodity or currency. Short hedges involve the sale of a forward or a futures contract to cover a required future sale of a commodity or currency. Call options can be used to hedge future purchase requirements, and put options can be used to hedge future sales commitments.