Question

Vernon Glass Company has $20 million in 10 percent, $1,000 par value convertible bonds outstanding. The conversion ratio is 60, the stock price is $16, and the bond matures in 20 years. The bonds are currently selling at a conversion premium of $40 over their conversion value.

If the price of the common stock rises to $22 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 $40 to $15. (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)

What is the RATE OF RETURN?

Answer 1

Par value of bond = $1,000

Coupon rate = 10%

Annual Coupon payment = $1,000 × 10%

= $100

Annual Coupon payment is $100.

Conversion ratio = 60

Current Price = $16

Current bond price = (conversion ratio × Current stock price) + Conversion premium

= (60 × $16) + $40

= $960 + $40

= $1000

Current Stock price is $1000

After one year

Stock price = $22

Current bond price = (conversion ratio × Current stock price) + Conversion premium

= (60 × $22) + $15

= $1,260 + $15

= $1,335

Stock price after one year is $1,335

Rate of return = ($1,335 + $100 - $1000) / $1000

= $435 / $1000

= 43.50%

Rate of return in one year is 43.50%.

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