Question

Coffee Masters is thinking about issuing convertible dentures. The investment banking firm that they were referred to thinks that they can issue convertible debentures with the following characteristics:

-9% coupon
-20-year maturity
-$1,000 par value
-Conversion price of $50/share

The executives of Coffee Masters are only willing to issue these debentures IF the after-tax cost of capital is less than 8%. If the after-tax cost of capital exceeds 8%, they are going to move onto 'Plan B'. Plan B consists of issuing non-convertible debt. Given the following information on the company, what is the minimum price per debenture that they are able to receive to keep the after-tax cost of the debenture at 8%?

-Coffee Masters current common stock price = $43/share
-They anticipate calling the convertible issue five years from now when the common stock price is likely to grow to $60/share
-They are in a 40% tax bracket

Answer 1

There are two types of debentures are thinking to issue. One is convertible dentures and other is non-convertible debt. So by issuing the non-convertible bonds it could not be able to convert to the equity share preference of bondholder. So it bears more risky if the market rate of interest falls down, economy reacts like the purchase of more stable bonds. Which provides high interest rate for holders. In order to keep the after-tax cost of 8%, the Coffee Masters must issue a bond at par, because it provides a 9% coupon rate for holders and after-tax cost might be (8-tax rate) = 4.8%