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 the firm’s B rating means that 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. As Duncan’s assistant, you have been asked to help in the decision process by answering the following questions.

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% 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, its last dividend was $1, and the dividend is expected to grow at a constant 8% 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 of 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 the consistent with the riskiness of the issue?

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