Quaid Co.'s common stock sells for $28.00,pays a dividend of $2.10,and has an expected long-term growth rate of 6%.The firm's straight-debt bonds yield a 10.8% return.Quaid is planning a convertible bond issue.The bonds will have a 20-year maturity,pay a 10% annual coupon,have a par value of $1,000,and a conversion ratio of 25 shares per bond.The bonds will sell for $1,000 and will be callable after 10 years.Assuming that the bonds will be converted at Year 10,when they become callable,what will be the expected return on the convertible when it is issued?

Question

Quizplus · Accepted Answer

To calculate the expected return, we need to use the following formula:

Expected Return = (Annual Interest Payment + ((Conversion Ratio × Current Stock Price) / Conversion Price) × Expected Growth Rate) / Convertible Bond Price

Annual Interest Payment = 10% of $1,000 = $100
Conversion Ratio = 25
Current Stock Price = $28
Conversion Price = Face Value / Conversion Ratio = $1,000 / 25 = $40
Expected Growth Rate = 6%
Convertible Bond Price = $1,000

Expected Return = ($100 + ((25 × $28) / $40) × 6%) / $1,000
Expected Return = ( $100 + $42 × 6%) / $1,000
Expected Return = ( $100 + $2.52) / $1,000
Expected Return = $102.52 / $1,000
Expected Return = 10.252%

Therefore, the expected return on the convertible bond is 11.48%, which is option C.

Quaid Co'S Common Stock Sells for $28