Convertible Bond

B is correct. A convertible bond is ideal for James's situation because it provides a bond floor (downside protection from the fixed coupon and principal repayment) while allowing participation in equity upside through the conversion option. If the stock rises, he can convert to shares and profit. If the stock falls, he still receives coupon payments and principal at maturity, limiting downside loss.

A doesn't address his downside risk concern; common stock exposes him to full equity volatility without protection. C provides downside protection but offers no upside participation in the growth he anticipates, defeating his growth thesis. D offers some downside protection through fixed dividends but lacks the conversion feature that allows equity participation, and preferred stock still carries more downside risk than bonds.

C is correct. The bondholder (investor) has the conversion option, not the issuer. This is a fundamental characteristic: the investor controls when (or if) to convert the bond into a predetermined number of common shares based on the fixed conversion ratio established at issuance.

A is incorrect because convertible bonds pay LOWER coupons than similar non-convertible bonds. Investors accept lower interest in exchange for the equity conversion privilege and potential upside. B is incorrect because the BONDHOLDER controls conversion, not the issuer (though the issuer may have a separate call feature to redeem the bond, which is different from forcing conversion). D is incorrect because convertible bonds DO have interest rate risk; they behave like bonds when the stock price is low, experiencing price declines when interest rates rise.

A is correct. Calculate conversion value: 25 shares × $45 per share = $1,125. Calculate parity price: $1,000 par value ÷ 25 shares = $40 per share. Parity price is where the conversion value equals the bond's par value. Since the stock trades at $45 (above the $40 parity price), the conversion value ($1,125) exceeds par value ($1,000), making conversion potentially attractive.

B incorrectly uses $1,000 as conversion value (that's par, not conversion value) and $45 as parity (that's current stock price, not parity). C correctly calculates conversion value but incorrectly uses current stock price as parity. D uses bond par as conversion value (wrong) but correctly identifies $40 parity price. Remember: parity price = bond par ÷ conversion ratio.

C is correct (the EXCEPT answer). The conversion ratio is FIXED at issuance and does NOT change based on stock performance. It represents the number of shares the bondholder will receive per bond upon conversion. While some convertible bonds have anti-dilution provisions for stock splits or dividends, routine performance-based adjustments are not a feature.

A is accurate: the bond floor (investment value based on coupon and principal) provides downside protection; even if the stock becomes worthless, the bond retains value as a debt instrument. B is accurate: convertible bonds pay lower coupons than comparable non-convertible bonds because investors accept lower interest in exchange for the conversion privilege. D is accurate: bondholders maintain creditor status (priority over equity holders) while having the option to convert and participate in equity appreciation.

B is correct. Statements 1, 2, and 3 are TRUE.

Statement 1 is TRUE: Conversion value = 20 shares × $55 = $1,100, which exceeds the $1,000 par value. The bond is trading above parity (parity price = $1,000 ÷ 20 = $50 per share; stock at $55 exceeds this).

Statement 2 is TRUE: The convertible bond pays 4% while comparable non-convertible bonds yield 6%. Investors accept the lower coupon in exchange for the equity conversion privilege and upside potential.

Statement 3 is TRUE: Since conversion value ($1,100) exceeds par value ($1,000), converting yields $100 immediate gain. However, bondholders should also consider future upside potential, coupon income, and tax implications before converting.

Statement 4 is FALSE: The bondholder controls the conversion decision, not the issuer through direct mandate. However, issuers can effectively force conversion by calling the bond when it trades above the call price—bondholders must then choose between accepting the call price or converting (and will convert if conversion value exceeds call price). This scenario is called "forced conversion" in industry terminology.