Q19-15BP Vernon Glass Company has \(15 mi... [FREE SOLUTION]

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Foundations Of Financial Management

Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen

Business Studies

16th Edition 路 768 pages

ISBN: 9781259277160

Chapter 5: Q19-15BP (page 626)

Vernon Glass Company has $15 million in 10 percent convertible bonds outstanding. The conversion ratio is 40, the stock price is $17, and the bond matures in 10 years. The bonds are currently selling at a conversion premium of $45 over their conversion value.
If the price of the common stock rises to $23 on this date next year, what would your rate of return be if you bought a convertible bond today and sold it in one year? Assume on this date next year, the conversion premium has shrunk from $45 to $20.

Short Answer

Expert verified

The rate of return is 43.45%.

Step by step solution

Meaning of Conversion price

The price at which the convertible security will get converted into the equity security of the business entity is known as the conversion price.

Computing rate of return

Calculating Conversion value

$\begin{matrix} C o n v e r s i o n 鈥� v a l u e = S t o c k 鈥� p r i c e 脳 C o n v e r s i o n 鈥� r a t i o \\ = $ 17 脳 40 \\ = $ 680 \end{matrix}$

Calculation current market price of the convertible bond

$\begin{matrix} C u r r e n t 鈥� m a r k e t 鈥� p r i c e = C o n v e r s i o n 鈥� v a l u e + C o n v e r s i o n 鈥� p r e m i u m \\ = $ 680 + $ 45 \\ = $ 725 \end{matrix}$

Calculation of price of the convertible bond on this day next year

Calculating Conversion value

$\begin{matrix} C o n v e r s i o n 鈥� v a l e = S t o c k 鈥� p r i c e 脳 C o n v e r s i o n 鈥� r a t i o \\ = $ 23 脳 40 \\ = $ 920 \end{matrix}$

Calculation current market price of the convertible bond

$\begin{matrix} C u r r e n t 鈥� m a r k e t 鈥� p r i c e = C o n v e r s i o n 鈥� v a l u e + C o n v e r s i o n 鈥� p r e m i u m \\ = $ 920 + $ 20 \\ = $ 940 \end{matrix}$

The bond has also paid $100 interest over the year (10 %, $1000)

Calculating the rate of return

$\begin{matrix} R a t e 鈥� o f 鈥� r e t u r n = \frac{C u r r e n t 鈥� m a r k e t 鈥� p r i c e - P r e v i o u s 鈥� m a r k e t 鈥� p r i c e + B o n d 鈥� i n t e r e s t}{P r e v i o u s 鈥� m a r k e t 鈥� p r i c e} \\ = \frac{$ 940 - $ 725 + $ 100}{$ 725} \\ = \frac{$ 325}{$ 725} \\ = 43.45 % \end{matrix}$

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Assets
	Book value	Liquidation value
Accounts receivables	\(1,400,000	\)1,200,000
Inventory	\(1,800,000	\)900,000
Machinery and equipment	\(1,100,000	\)600,000
Building and plant	\(4,200,000	\)2,500,000
Total assets	\(8,500,000	\)5,200,000

Liabilities and stockholder鈥檚 claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder鈥檚 claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder鈥檚 claims	\)900,000
Total liabilities and stockholder鈥檚 claims	$8,500,000

Assets
	Book value	Liquidation value
Accounts receivables	\(1,400,000	\)1,200,000
Inventory	\(1,800,000	\)900,000
Machinery and equipment	\(1,100,000	\)600,000
Building and plant	\(4,200,000	\)2,500,000
Total assets	\(8,500,000	\)5,200,000

Liabilities and stockholder鈥檚 claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder鈥檚 claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder鈥檚 claims	\)900,000
Total liabilities and stockholder鈥檚 claims	$8,500,000

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Short Answer

Step by step solution

Meaning of Conversion price

Computing rate of return

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