S&S Air’s Convertible BondChris Guthrie was recently hired by S&S Air, Inc., to assist the company with its short-termfi nancial planning and to evaluate the company’s performance. Chris graduated from collegefi ve years ago with a fi nance degree. He has been employed in the fi nance department of aFortune 500 company since then.S&S Air was founded 10 years ago by two friends, Mark Sexton and Todd Story. The companyhas manufactured and sold light airplanes over this period, and the company’s productshave received high reviews for safety and reliability. The company has a niche market in thatit sells primarily to individuals who own and fl y their own airplanes. The company has twomodels: the Birdie, which sells for $53,000, and the Eagle, which sells for $78,000.S&S Air is not publicly traded, but the company needs new funds for investment opportunities.In consultation with Tonisha Jones of underwriter Raines and Warren, Chris decided that a convertible bond issue with a 20-year maturity is the way to go. He met with the owners, Markand Todd, and presented his analysis of the convertible bond issue. Because the company is notpublicly traded, Chris looked at comparable publicly traded companies and determined that theaverage PE ratio for the industry is 12.5. Earnings per share for the company are $1.60. Withthis in mind, Chris concluded that the conversion price should be $25 per share.Several days later Todd, Mark, and Chris met again to discuss the potential bond issue. BothTodd and Mark have researched convertible bonds and have questions for Chris. Todd begins byasking Chris if the convertible bond issue will have a lower coupon rate than a comparable bondwithout a conversion feature. Chris replies that to sell the bond at par value, the convertible bondissue would require a 6 percent coupon rate with a conversion value of $800, while a plain vanillabond would have a 7 percent coupon rate. Todd nods in agreement, and he explains that theconvertible bonds are a win–win form of fi nancing. He states that if the value of the companystock does not rise above the conversion price, the company has issued debt at a cost below themarket rate (6 percent instead of 7 percent). If the company’s stock does rise to the conversionvalue, the company has effectively issued stock at above the current value.Mark immediately disagrees, arguing that convertible bonds are a no-win form of fi nancing.He argues that if the value of the company stock rises to $25, the company is forced to sellstock at the conversion price. This means the new shareholders (those who bought the convertiblebonds) benefi t from a bargain price. Put another way, if the company prospers, it would havebeen better to have issued straight debt so that the gains would not be shared.Chris has gone back to Tonisha for help. As Tonisha’s assistant, you’ve been asked toprepare another memo answering the following questions:1. Why do you think Chris is suggesting a conversion price of $25? Given that the companyis not publicly traded, does it even make sense to talk about a conversion price?2. What is the fl oor value of the S&S Air convertible bond?3. What is the conversion ratio of the bond?4. What is the conversion premium of the bond?5. What is the value of the option?6. Is there anything wrong with Todd’s argument that it is cheaper to issue a bond with aconvertible feature because the required coupon is lower?7. Is there anything wrong with Mark’s argument that a convertible bond is a bad ideabecause it allows new shareholders to participate in gains made by the company?8. How can you reconcile the arguments made by Todd and Mark?9. During the debate, a question comes up concerning whether the bonds should have anordinary (not make-whole) call feature. Chris confuses everybody by stating, “The callfeature lets S&S Air force conversion, thereby minimizing the problem Mark has identified.’’ What is he talking about? Is he making sense?