Suppose you are evaluating a bond that can be exchanged for shares of the issuing company's stock at a conversion price of $5 per share. The bond has a $50 annual coupon, ﬁve years to
Maturity, and straight debt of the same risk is priced to yield 8%. The current share price for the
Issuing ﬁrm is $4.50. What is the minimum value for which the bond should sell?
A) $848.37
B) $880.22
C) $900.00
D) $921.12
E) $1,000.00

Question

Quizplus · Accepted Answer

To determine the minimum value for which the bond should sell, we need to calculate the bond's value as straight debt and as if it were converted to stock. Whichever value is higher will be the minimum price at which the bond should sell.

As straight debt: 
PV = C/r * (1 - 1/(1+r)^n) + FV/(1+r)^n
PV = 50/0.08 * (1 - 1/(1+0.08)^5) + 1000/(1+0.08)^5
PV = $846.31

If the bond were converted to stock, the holder would receive shares worth $5 per share. Therefore, the number of shares received would be $1000/$5 = 200.

If the current share price is $4.50, the value of the shares received upon conversion is: 
200 * $4.50 = $900

Since $900 is higher than $846.31, the minimum price at which the bond should sell is $900. Therefore, the best choice is C.

Suppose You Are Evaluating a Bond That Can Be Exchanged