Rizzo Company has debentures ($1,000 par) outstanding that are convertible into the company's common stock at a price of $25. The convertibles have a coupon interest rate of 8% and mature in 12 years. In addition, the convertible debenture is callable at 110% of the par value. Straight debt of equivalent risk is yielding 12%. The company's common stock is selling at $22 per share. The company has a marginal tax rate of 40%. Determine the straight-bond value of the issue.
A) $1,000
B) $496
C) $880
D) $753

Question

Quizplus · Accepted Answer

To determine the straight-bond value of the issue, we need to calculate the present value of the convertible debentures' cash flows as if they were regular bonds paying only interest (i.e., not considering the conversion option). We can use the following formula:

PV = C x [1 - 1/(1+r)^n] / r + F/(1+r)^n

Where:
PV = present value of the cash flows
C = annual coupon payment = $1,000 x 8% = $80
r = required rate of return = 12%
n = number of years to maturity = 12
F = face value of the bond = $1,000

PV = $80 x [1 - 1/(1+12%)^12] / 12% + $1,000/(1+12%)^12
PV = $600.08 + $254.69
PV = $854.77

Therefore, the straight-bond value of the convertible debentures is $854.77. The closest choice is D, $753, so that is the best answer.

Rizzo Company Has Debentures ($1,000 Par) Outstanding That Are Convertible