Omnicom wants to issue $100 million worth of convertible debentures (100,000 bonds issued at par value of $1,000 per bond). They would like the coupon rate to be very low to save on cash interest. Their investment banker tells them that zero coupon convertibles might be the right thing for them. (A zero coupon convertible is just a convertible bond with the coupon rate set to zero.) Suppose that Omnicom was considering a maturity of five years. Given Omnicom’s credit quality, if they issued straight (i.e., non-convertible) zero coupon debt with five years to maturity, they would have to pay an annual yield of 8%. The stock price of Omnicom is $25 per share. a.
Assuming the bond is initially priced at par, calculate the value of the option to buy the stock by exchanging the bond for the shares.