Defense Systems Inc. has convertible bonds outstanding that are callable at \(1,070. The bonds are convertible into 33 shares of common stock. The stock is currently selling for \)39.25 per share.

1. If the firm announces it is going to call the bonds at \(1,070, what action are bondholders likely to take and why?
2. Assume that instead of the call feature, the firm has the right to drop the conversion ratio from 33 down to 30 after 5 years and down to 27 after 10 years. If the bonds have been outstanding for 4 years and 11 months, what will the price of the bonds be if the stock price is \)40? Assume the bonds carry no conversion premium.
3. Further assume that you anticipate that the common stock price will be up to $42.50 in two months. Considering the conversion feature, should you convert now or continue to hold the bond for at least two more months?

Step by step solution

01

Meaning of Common Stock

Common stock refers to the fundamental kind of ownership in a company. To put it another way, it's a method of allocating corporate ownership; as a result, each share of common stock equates to a specific fraction of an organization.

02

(a) Explaining the action taken by bondholders

The bondholders will likely be converted bonds to common stock. The converted securities would be worth $1,295 with a conversion ratio of 33 shares and a common stock price of $39.25. This is significantly more than the $1,070 call value. There is a substantial incentive to convert as a result.

03

(b) Calculating the price of bonds

$\begin{array}{rcl}\mathit{B}\mathit{o}\mathit{n}\mathit{d}\mathbf{}\mathit{p}\mathit{r}\mathit{i}\mathit{c}\mathit{e}& \mathbf{=}& \mathit{S}\mathit{t}\mathit{o}\mathit{c}\mathit{k}\mathbf{}\mathit{p}\mathit{r}\mathit{i}\mathit{c}\mathit{e}\mathbf{\times }\mathit{C}\mathit{o}\mathit{n}\mathit{v}\mathit{e}\mathit{r}\mathit{s}\mathit{i}\mathit{o}\mathit{n}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}\\ & \mathbf{=}& \mathbf{\$}\mathbf{40}\mathbf{\times }\mathbf{33}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{320}\\ & & \end{array}$

04

(c) Explaining the situation whether to hold the bond for at least two more months

Calculation of bond price in two months

$\begin{array}{rcl}\mathit{B}\mathit{o}\mathit{n}\mathit{d}\mathbf{}\mathit{p}\mathit{r}\mathit{i}\mathit{c}\mathit{e}\mathbf{}\mathit{i}\mathit{n}\mathbf{}\mathit{t}\mathit{w}\mathit{o}\mathbf{}\mathit{m}\mathit{o}\mathit{n}\mathit{t}\mathit{h}& \mathbf{=}& \mathit{S}\mathit{t}\mathit{o}\mathit{c}\mathit{k}\mathbf{}\mathit{p}\mathit{r}\mathit{i}\mathit{c}\mathit{e}\mathbf{\times }\mathit{C}\mathit{o}\mathit{n}\mathit{v}\mathit{e}\mathit{r}\mathit{s}\mathit{i}\mathit{o}\mathit{n}\mathbf{}\mathit{r}\mathit{a}\mathit{t}\mathit{i}\mathit{o}\\ & \mathbf{=}& \mathbf{\$}\mathbf{42}\mathbf{.}\mathbf{50}\mathbf{\times }\mathbf{30}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{275}\\ & & \end{array}$

Instead of keeping the bonds for another two months, we should convert right now.

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