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Vernon Glass Company has $20 million in 10 percent convertible bonds outstanding. The conversion ratio is...

Vernon Glass Company has $20 million in 10 percent 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.)

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Answer #1

ASSUMPTION: Convertible Bond has a face value of $ 1000

Bond Coupon Rate = 10%

At current time (t=0):

Conversion Ratio = 60 and Stock Price = $ 16, Conversion Premium = $ 40

Bond Price = P0 = Conversion Ratio x Stock Price + Conversion Premium = 60 x 16 + 40 = $ 1000

At time one year later (t=1):

Conversion Ratio = 60, Stock Price = $ 22 and Conversion Premium = $ 15

Bond Price = P1 = 60 x 22 + 15 = $ 1335 and Bond Coupon = Coupon Rate x Face Value = 0.1 x 1000 = $ 100

Rate of Return = [(P1 - P0) + Dividend] / P0 = [(1335-1000) + 100] / 1000 = 0.435 or 43.5 %

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