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 with the firm's B rating, the 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.

The following data apply to all three alternatives:

Inputs (Note: All values are in millions, except per share data.)

Value of operations $500.00
Number of shares outstanding 20
Expected growth rate of FCF 8.00%
Current stock price $20.00
Cost of equity, rs 13.40%
Interest rate on straight debt, rd 10.00%
Tax rate 40.00%

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

a. How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock? Answer: See Chapter 20 Mini Case Show
b. What is a call option? How can a knowledge of call options help a financial manager to better understand warrants and convertibles? Answer: See Chapter 20 Mini Case Show
c. Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and focus on the others. EduSoft's investment banker estimates that EduSoft could issue a bond with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a strike price of $25 and 10 years until expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%.
(1) What coupon rate should be set on the bond with warrants if the total package is to sell for $1,000?
Find the payment such that the bond with warrant is issued at par.
Find the payment such that the bond with warrant is issued at par.
(2) When would you expect the warrants to be exercised? What is a stepped-up-exercise price? Answer: See Chapter 20 Mini Case Show

(3) Will the warrants bring in additional capital when exercised? If EduSoft issues 100,000 bond-with-warrant packages, how much cash will EduSoft receive when the warrants are exercised? How many shares of stock will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding).

How much cash will the firm receive when the warrants are exercised?
How many shares of stock will there be after the warrants are exercised?
(4) Because the presence of warrants causes a lower coupon rate on the accompanying debt issue, shouldn't all debt be issued with warrants? To answer this, estimate the expected stock price in 10 years when the warrants are expected to be exercised, 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.

The cost of debt debt is the cost of straight debt = rd =
How much will the bonds be worth in 10 years? (There will be 10 years remaining to maturity.)
Intrinsic stock price per share after exercise =
Strike price of each warrant =

Profit per warrant after exercise =

Number of warrants per bond =

Profit per bond from exercising warrants =

N = Number of years until exercise =
PV = Intitial cost of warrants =
PMT = zero =
FV = Cash flow at exercise =

RATE = Component cost of warrants per bond =

(5) 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%)?
(6) If the corporate tax rate is 40%, what is the after-tax cost of the bond with warrants?
d. 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 percent annual coupon, callable convertible bond for its $1,000 par value, whereas a straight-debt issue would require a 12 percent coupon. 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, its last dividend was $1.00, and the dividend is expected to grow at a constant 8 percent rate. The convertible could be converted into 40 shares of EduSoft stock at the owner's option.

(1) What conversion price is built into the bond?
(2) What is the convertible's 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 percent 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 return on the convertible to EduSoft? Does this cost appear to be consistent with the convertible bond's risk?

(7) What is the after-tax cost of the convertible bond?
e. Mr. Duncan believes that the costs of both the bond with warrants and the convertible bond are close enough to one another to call them even, and also consistent with the risks involved. Thus, he will make his decision based on other factors. What are some of the factors which he should consider?

f. How do convertible bonds help reduce agency costs?