The common stock of the Blue Sky Corporation earns $3 per share, has a 60 percent dividend payout, and sells at a P/E ratio of 8.333. Blue Sky wishes to offer $10 million of 9 percent, 20 year convertible debentures with an initial conversion premium of 20 percent and a call price of 105 ($1,050 per $1,000 face value). Blue Sky currently has 1 million common shares outstanding and has a 40 percent tax rate.
a. What is the conversion price?
b. What is the conversion ratio per $1,000 debenture?
c. What is the initial conversion value of each debenture?
d. How many new shares of common stock must be issued if all debentures are converted?
e. If Blue Sky can increase operating earnings (before taxes) by $1 million per year with the proceeds of the debenture issue, compute the new earnings per share and earnings retained before and after conversion.