Question

S&S AIR'S CONVERTIBLE BOND Chris Guthrie was recently hired by S&S Air, Inc., to assist the company with its short-term financial planning and to evaluate the company's performance. Chris graduated from college five years ago with a finance degree. He has been employed in the finance department of a Fortune 500 company since then. S&S Air was founded 10 years ago by two friends, Mark Sexton and Todd Story. The company has manufactured and sold light airplanes over this period, and the company's prod- ucts have received high reviews for safety and reliability. The company has a niche market in that it sells primarily to individuals who own and fly their own airplanes. The company has two models: the Birdie, which sells for $53,000, and the Eagle, which sells for $78,000. S&S Air is not publicly traded, but the company needs new funds for investment oppor- tunities. In consultation with Tonisha Jones of underwriter Raines and Warren, Chris decided that a convertible bond issue with a 20-year maturity is the way to go. He met with the owners, Mark and Todd, and presented his analysis of the convertible bond issue. Because the company is not publicly traded, Chris looked at comparable publicly traded companies and determined that the average PE ratio for the industry is 17.5. Earnings per share for the company are $1.75. With this in mind, Chris concluded that the conversion price should be $45 per share. Several days later, Todd, Mark, and Chris met again to discuss the potential bond issue. Both Todd and Mark have researched convertible bonds and have questions for Chris. Todd begins by asking Chris if the convertible bond issue will have a lower coupon rate than a comparable bond without a conversion feature. Chris replies that to sell the bond at par value, the convertible bond issue would require a 5 percent coupon rate with a conversion value of $680.56, while a plain vanilla bond would have an 8 percent coupon rate. Todd nods in agree- ment, and he explains that the convertible bonds are a win-win form of financing. He states that if the value of the company stock does not rise above the conversion price, the company has issued debt at a cost below the market rate (5 percent instead of 8 percent). If the com- pany's stock does rise to the conversion value, the company has effectively issued stock at above the current value. Mark immediately disagrees, arguing that convertible bonds are a no-win form of financ- ing. He argues that if the value of the company stock rises to $45, the company is forced to sell stock at the conversion price. This means the new shareholders (those who bought the convertible bonds) benefit from a bargain price. Put another way, if the company prospers, it would have been better to have issued straight debt so that the gains would not be shared.

Answer 1

Given:

P/E Ratio = 17.5

EPS = $1.75

Conversion Price = $ 45

Coupon Rate of Convertible Bond = 5%

Conversion Value = $ 680.56

Required :

(i)

Formula : P/E = MPS / EPS

Using the P/E ratio to obtain the MPS

17.5 = MPS / 1.75

MPS = $ 30.625

This means as per the current industry trend of this sector the share price is quoting at around $ 30.625

However, S&S is quoting a price of $ 45 , which means it is at a premium of 46.94%.

The conversion price is important because if the investors have to benefit, the price has to increase beyond this.

It also has to be noted that the company may go public in the future, which will give the investors an active secondary market for trading.

Even if the company does not go public, there will be an equity interest for the bond holders and they can benefit if the company does well.

Req (ii)

Formula : Floor Value = ( Higher of Intrinsic Value & Conversion Value)

Conversion Value = $ 680.56

Note: Since rate of interest for discounting is not given in the question , assumed to be 4%

Intrinsic Bond Value = Coupon Payment * PVAF(r%,n) + Redemption Value * PVIF(r%,N)

Intrinsic Bond Value = 50 * PVAF _(4%,20) + 1000 * PVIF _(4%,20)

= $ 1135.82

Therefore, floor value is $ 680.56

Req (iii)

Formula: Conversion Ratio = Par Value of Bond / Conversion Price

Applying the formula;

Conversion Ratio =1000/45

                                  = 22.22

Req (iv)

Formula: Conversion Premium = {(Conversion Price – Conversion Value )/ Conversion Value } * 100

Applying the formula;

Conversion Premium (%) = { (45 – 30.625) / 30.625} * 100

                                         = 46.94 %

Conversion Premium ($) = 45 – 30.625

                                              = $ 14.375