Question

Hrustic Company issued $750,000 of 12% convertible bonds at face value on an interest payment date several years ago. The face value of each bond is $1,000, and each bond is convertible into 25 shares of $1 par common stock. Hrustic has embarked on a program of debt reduction; U.S. interest rates have declined during the term of the convertible bonds. Consequently, Hrustic offers the convertible bondholders $500 cash per bond as an inducement to convert. The market price of Hrustic stock is currently $70 per share. The bonds must be converted within a three-month period to receive the cash inducement. The bondholders accept the inducement and convert within the required period. Required:Explain why the bondholders decided to convert their bonds into shares of common stock.Record the conversion using the book value method.

Answer 1

Answer: The bondholders decided to convert the bonds into common stock because they believed that getting $2250 today is worth more than $120 interest every year and a $1000 principal payment at the end of the bonds life.

Explanation:

1) In order to find out the number of bonds issued we need to divide 750,000 (Total ) by 1000(Face value of each bond).Total number of bonds issues therefore are 750.

2) A 12 percent convertible bond means that the bond pays a coupon of 120 ( 0.12 * 1000) every year.

3) Each bond is convertible into 25 shares , which means if one bond is converted into common stock, the bond holder can earn $1750. We calculate this number by multiplying the number of shares which is 25 into the current market price of the shares which is 70.

4) Also the company is offering an extra  $500 per bond for converting it which means (500/25) an extra $20 per share.

5) So in total the bondholder by converting a bond and selling the shares he gets by converting it can earn $2250 per bond which they bought for a $1000 and gives them 120$ of interest every year.

6) SO to conclude the bondholders decided to convert the bonds into common stock because they believed that getting $2250 today is worth more than $120 interest every year and a $1000 principal payment at the end of the bonds life.