Question

Tulsa Drilling Company has $1.5 million in 14 percent convertible bonds outstanding. Each bond has a $1,000 par value. The conversion ratio is 50, the stock price is $31, and the bonds mature in 10 years. The bonds are currently selling at a conversion premium of $80 over the conversion value. Use Appendix B and Appendix D as an approximate answer, but calculate your final answer using the formula and financial calculator methods.

a. Today, one year later, the price of Tulsa Drilling Company common stock has risen to $41. What would your rate of return be if you had purchased the convertible bond one year ago and sold it today? Assume that on the date of sale, the conversion premium has shrunk from $80 to $30. (Hint: Don’t forget to include the interest payment for the first year) (Do not round intermediate calculations. Input your answer as a percent rounded to 2 decimal places.)
  

b-1. Assume the yield on similar nonconvertible bonds has fallen to 12 percent at the time of sale. What would the pure bond value be at that point? (Use semiannual analysis.) (Do not round intermediate calculations. Round your final answer to 2 decimal places.)
  

b-2. Would the pure bond value have a significant effect on valuation then?
  

	Yes
	No

Answer 1

(a) Coupon Rate = 14 %, Par Value = $ 1000, Tenure = 10 years, Conversion Ratio = 50 and Conversion Price = $ 31, Conversion Premium = $ 80

Bond Purchase Price = 50 x 31 + 80 = $ 1630

At the end of Year 1:

Conversion Premium = $ 30, Conversion Price = $ 41

Therefore, Sale Price = 41 x 50 + 30 = $ 2080

Interest Paid = Coupon Payment = 0.14 x 1000 = $ 140

Therefore, Total Investor Return = [(2080 + 140) - 1630] / 1630 = 0.36196 or 36.196 % ~ 36.2 %

(b) Yield of Pure Bonds = 12 %, Remaining Tenure = 9 years

Therefore, Pure Bond Price = 140 x (1/0.12) x [1-{1/(1.12)^(9)}] + 1000 / (1.12)^(9) = $ 1106.56

(c) The pure bond price will not have a significant impact on valuation, as the same is majorly based on the underlying stock's price, conversion premium and conversion ratio.