Question

Vernon Glass Company has $20 million in 10 percent, $1,000 par value convertible bonds outstanding. The conversion ratio is 40, the stock price is $22, and the bond matures in 15 years. The bonds are currently selling at a conversion premium of $55 over their conversion value.

If the price of the common stock rises to $28 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 $55 to $20. (Hint: Calculate
rate of return as (Future bond price − Current bond price +
Interest earnings) / Current bond price))

Answer #1

Coupon payment = 1000 * 10% = $ 100

Current convertible bond price = ( current Stock price * conversion ratio ) + Conversion premium

=( 22 * 40) + 55

current convertible bond price = $ 935

After One year, Convertible bond price :-

Bond price = ( current Stock price * conversion ratio ) + Conversion premium

= (28 * 40) + 20

Bond price after one year = $ 1140.

Rate of return = ( Bond price after one year + Coupon payment - current bond price ) / current bond price

=( 1140 +100 - 935) / 935

Rate of return =32.62%

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