United Technology Corporation (UTC) has \(40 million of convertible bonds outstanding (40,000 bonds at \)1,000 par value) with a coupon rate of 11 percent. Interest rates are currently 8 percent for bonds of equal risk. The bonds have 15 years left to maturity. The bonds may be called at a 9 percent premium over par. They are convertible into 30 shares of common stock. The tax rate for the company is 25 percent.

The firm’s common stock is currently selling for \(41, and it pays a dividend of \)3.50 per share. The expected income for the company is $38 million with 6 million shares outstanding.

Thoroughly analyze the bond and determine whether the firm should call the bond at the 9 percent call premium. In your analysis, consider the following:

a. The impact of the call on basic and diluted earnings per share (assume the call forces conversion).

b. The consequences of your decision on financing flexibility.

c. The net change in cash outflows to the company as a result of the call and conversion.

Step by step solution

01

Step 1:Computation of interest expense-

$\begin{array}{rcl}\mathbf{Interestexpense}& \mathbf{=}& \mathbf{Couponrate}\mathbf{\times }\mathbf{Convertiblebondsoutstanding}\\ & \mathbf{=}& \mathbf{11}\mathbf{\%}\mathbf{\times }\mathbf{\$}\mathbf{40}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{400}\mathbf{,}\mathbf{000}\\ & & \end{array}$

02

Computation of shares created from conversion-

$\begin{array}{rcl}\mathbf{Sharescreatedfromconversion}& \mathbf{=}& \mathbf{Commonstock}\mathbf{\times }\mathbf{Bonds}\\ & \mathbf{=}& \mathbf{30}\mathbf{\times }\mathbf{40}\mathbf{,}\mathbf{000}\\ & \mathbf{=}& \mathbf{1}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}\\ & & \end{array}$

03

 tep 3:Computation of conversion value-

$\begin{array}{rcl}\mathbf{Conversionvalue}& \mathbf{=}& \mathbf{Shares}\mathbf{\times }\mathbf{Pricepershare}\\ & \mathbf{=}& \mathbf{30}\mathbf{\times }\mathbf{\$}\mathbf{41}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{230}\\ & & \end{array}$

04

Step 4:Computation of call price-

$\begin{array}{rcl}\mathbf{Callprice}& \mathbf{=}& \mathbf{Parvalue}\mathbf{\times }\left(\mathbf{1}\mathbf{+}\mathbf{Premium}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{000}\mathbf{\times }\mathbf{1}\mathbf{.}\mathbf{09}\\ & \mathbf{=}& \mathbf{\$}\mathbf{1090}\\ & & \end{array}$

05

Step 5:Computation of basic earnings per share before conversion-

$\begin{array}{rcl}\mathbf{Basicearningspershare}& \mathbf{=}& \frac{\mathbf{NetIncome}}{\mathbf{Sharesoutstanding}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{38}}{\mathbf{\$}\mathbf{6}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{6}\mathbf{.}\mathbf{33}\end{array}$

06

Step 6:Computation of basic earnings per share after conversion-

$\begin{array}{rcl}\mathbf{BasicEarningspershare}& \mathbf{=}& \frac{\mathbf{Adjustedearningsaftertaxe}}{\mathbf{Sharesoutstanding}\mathbf{+}\mathbf{Newsharesissued}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{38}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{4}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{\times }\left(\mathbf{1}\mathbf{-}\mathbf{0}\mathbf{.}\mathbf{25}\right)}{\mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \frac{\mathbf{\$}\mathbf{41}\mathbf{,}\mathbf{000}\mathbf{,}\mathbf{000}}{\mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{200}\mathbf{,}\mathbf{000}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{5}\mathbf{.}\mathbf{69}\\ & & \end{array}$

07

Step 7:(b) Consequences of your decision on financing flexibility-

The company has reduced its debt and increased the equity financing with the elimination of the convertible bond. It provides more flexibility in the way of debt issues for the future. With the recent interest rate at 8% the company may sell a new issue of straight debt and again purchase shares of common stock. It will serve the purpose of a partial refund that will result in a lower outlay for interest and dividends. Thus, flexibility is enhanced.

08

Step 8:(c) Net change in cash outflows-

After tax dividend expense ($3.50*1,200,000)	$4,200,000
Less: After tax interest expense [$4,000,000*(1-0.25)	($3,000,000)
After tax net cash outflow	$1,200,000

Unlock Step-by-Step Solutions & Ace Your Exams!

• Full Textbook Solutions

  Get detailed explanations and key concepts

• Unlimited Al creation

  Al flashcards, explanations, exams and more...

• Ads-free access

  To over 500 millions flashcards

• Money-back guarantee

  We refund you if you fail your exam.

Start your free trial

Over 30 million students worldwide already upgrade their learning with Vaia!