Investinus, Inc. issues a convertible bond with a face value of $120, with the option to convert the bond into 3 shares of stock in the company. Draw the payoff diagram of the convertible bond.
Can you replicate the payoff diagram for the convertible bond with a portfolio consisting of a regular (i.e. non- convertible) bond and one or more call options on Investinus stock?
(Assume calls are written on single shares of stock). If so, describe the portfolio of calls and (non-convertible) bonds which replicates the convertible bond. State the Modigliani-Miller theorem 2 (MM2).Make sure to clearly describe the assumption (s)).
Now use this result to show that (under the assumptions of MM2) a firm's (weighted average) cost of capital is independent of its capital structure. Smart Options, Inc. has no debt. Its assets will be worth $450 million in one year if the economy is strong, but only$200 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is $250 million.
Suppose the risk-free interest rate is 5%. If SO borrows$100 million today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the dividend is paid?
What is the (expected) return rate on SO stock after the dividend is paid in part (1)?