Paul Duncan, the financial manager of EduSoft Inc,. is contemplating the need to raise new capital, to grab a larger market share before an imminent shakeout of the education software industry. In this case study, the concepts of a preferred stock, warrants, and convertible bonds are discussed. Also, the cost of capital of a bond with warrants package and that for a convertible bond are explored, and the call option features of both financing options are discussed. In addition, the case study includes a discussion on the considerations behind choosing one of the financing options over the other, as well as how convertible bonds could reduce agency costs.
Analysis
EduSoft Inc. was founded 5 years ago to provide educational software for the rapidly…show more content… Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and focus on the others. EduSoft’s investment banker estimates that EduSoft could issue a bond-with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a stike price of $25 and 10 years unitil expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%.
Part c1. What coupon rate should be set on the bond with warrants if the total package is to sell at par ($1,000)?
Answer. Each warrant has a value of $5, so 27 warrants = 27 x $5 = $135. According to Brigham and Ehrhardt (2014), the price paid for bond with warrants = straight-debt value of bond + value of warrants. Therefore the straight-debt value of bond = price of bond-with-warrants package – value of warrants = $1,000 - $135 = $865.
The going interest rate per year = 10%, the number of years, N = 20, future value, FV = 1,000, and present value, PV = 865.
Putting the values into the excel function PMT(rate, nper, pv, [fv], [type]), one gets the yearly payment amount PMT = $84.14.
At the par of $1,000, the PMT of $84.14 represent a coupon rate of…show more content… How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock (which is 13.4%)?
As illustrated in part c4, the cost of the bond with warrants package (at 10.31%) is higher than the cost of straight debt (at 10%) because warrants are riskier than debt. However, although warrants are also lllriskier than common stock, the cost of the package is lower than the cost of common stock because the warrants component at $135 comprise only 13.5% of the value of the package.
Part c6. If the corporate tax rate is 40%, whiat is the after-tax cost of the bobd with warrants?
With a corporate tax of 40%, one needs to determine the after-tax cost of each component of the package to obtain the after-tax cost of the package. The after-tax cost of the warrant is the same as the pre-tax csot because warrants do not affect the issuer’s tax liability. However, the after-tax cost of the bond component can be estimated as rd(1-T) for long-term debt, even though in reality it would be higher than 10%(1-40%) = 6%.
The after-tax cost of the bond with warrants package = 10% (1-40%)($865/$1000) + 12.31% ($135/$1000) =