(Solution) - Suppose you just bought a convertible bond at its par -(2025 Original AI-Free Solution)

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Suppose you just bought a convertible bond at its par value. Your broker gives you information on the bond?s conversion ratio, coupon rate, maturity, years of call protection, and the yield on non convertible bonds of similar risk and maturity. The company has a well-established payout ratio, and you also know the stock?s price, beta, and expected ROE. You also know the risk-free rate and the market risk premium.
a. How could you use this information, to determine how much you are paying for the option to convert?
b. How would you determine the expected rate of return on the convertible, along with the expected return on the common stock and the straight bonds?
c. Now suppose the company unexpectedly announced
(1) An increase in its target dividend payout ratio from, say, 25% to 75% and
(2) An increase in the dividend from $1 to $3 to conform to the new policy. Would the new dividend policy help or hurt you and other holders of the convertible bond? Explain.