Niendorf Incorporated needs to raise $25 million to construct production facilities for a new type of USB memory device. The firm"s straight nonconvertible debentures currently yield 9%. Its stock sells for $23 per share, has an expected constant growth rate of 6%, and has an expected dividend yield of 7%, for a total expected return on equity of 13%. Investment bankers have tentatively proposed that the firm raise the $25 million by issuing convertible debentures. These convertibles would have a $1,000 par value, carry a coupon rate of 8%, have a 20-year maturity, and be convertible into 35 shares of stock. Coupon payments would be made annually. The bonds would be noncallable for 5 years, after which they would be callable at a price of $1,075; this call price would decline by $5 per year in Year 6 and each year thereafter. For simplicity, assume that the bonds may be called or converted only at the end of a year, immediately after the coupon and dividend payments. Also assume that management would call eligible bonds if the conversion value exceeded 20% of par value (not 20% of call price).
a. At what year do you expect the bonds will be forced into conversion with a call? What is the bond"s value in conversion when it is converted at this time? What is the cash flow to the bondholder when it is converted at this time? (Hint: The cash flow includes the conversion value and the coupon payment, because the conversion occurs immediately after the coupon is paid.)
b. What is the expected rate of return (i.e., the before-tax component cost) on the proposed convertible issue?