Question #51 - Reading 27 Valuation and Analysis of Bonds With Embedded Options

Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers

PDF File: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers.pdf

Page: 21

Status: Unattempted

Shared Context

- Assuming the common stock of MediSoft underwent a one-for-two reverse split, how would the features of the company's bonds be adjusted? The: A) conversion value of the convertible bond would be reduced by half. B) market conversion price of the convertible bond would be reduced by half. C) conversion ratio of the convertible bond would be reduced by 50%. Explanation A stock split would affect the market price of the common stock and the conversion ratio of a convertible bond. Since the split is a one-for-two split, the number of shares outstanding in the marketplace will be reduced by one half. Therefore, the stock price will double, keeping the total market value of the stock the same. Upon a stock split (or a reverse stock split), the conversion ratio is adjusted to reflect the split. In this case, the conversion ratio would be reduced by half. The market conversion price would double (the price of the bond is unchanged, but the conversion ratio decreases by 50%). (Module 27.8, LOS 27.o)

Question

Under what circumstances will the analyst's comments regarding the limited downside risk of MediSoft's convertible bonds be accurate?

Answer Choices:

A. The convertible bond is trading in the market as a common stock equivalent

B. Short-term and long-term interest rates are expected to remain the same

C. The Federal Reserve Bank decides to pursue a restrictive monetary policy. Explanation If interest rates are not expected to change then the straight value of the bond will not change (ignoring the change in value resulting from the passage of time). If the straight value does not change, then downside risk is indeed limited to the difference between the price paid for the bond and the straight value. If, however, interest rates rise as the price of the common stock falls, the conversion value will fall and the straight value will fall, exposing the holder of the convertible bond to more downside risk. (Module 27.8, LOS 27.o)

Actions

Practice Flashcards