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PGDM 2009-2011

Financial Markets and Instruments


TERM IV
Case Analysis on
Wells Fargo Convertible Bonds

Submitted to:
Prof. Kulbir Singh
Section B2CD1
Submitted by

Mikhail Parmar -2009129


Nikeeta Kataruka-2009146
Oormila Ram 2009148
Neha Patet -2009317
Hitansh Vij - 2009110

Introduction
Wells Fargo & Co. The central question in this case is whether Wells Fargo should issue
Convertible debt or not. If not Wells Fargo, ideally or theoretically speaking who should issue
convertible debt? The discussion can revolve around the qualitative aspects of the convertible
debt. The case also highlights the opportunistic financing and Atkins philosophy of raising
capital.
We will be analysing the case from two points of view. From the companys point of view as
well as the investors point of view.
Whether Wells Fargo and Co. should go ahead with the bonds issue or not?
1.1 History repeats itself
The table below shows the historical price, PE and EPS over the past 3 years.
Date

Price$

EPS$

P/E
11.9449

31-12-2000

28.19

2.36

2
11.0050

31-12-2001

21.9

1.99

3
7.42006

31-12-2002
01-04-2003

23.67
23.2

3.19
2.11

3
11

Although in the case it is mentioned that the price of Wells Fargo & Co. on 25th April 2003
was 47.45, we have found out that the actual price of the company was When one looks at the
historical earnings of Wells Fargo & Co. we can see that over the past two years it has grown
at a CAGR of 16.38%.
For Wells Fargo & Co. to reach $120 in 5 years the company would have to grow at a rate of
20.38%, if we assume that the current share price is fairly valued. Therefore, according to us,
to have a sustainable growth rate of 20.38% is very difficult and hence the share price
reaching $120 within 5 years is a rare occasion.
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1.2 Tax Benefits for Wells Fargo if the bonds are issued
In the case it is mentioned that according to IRS rules, Wells Fargo would be eligible for
deduction from income an interest amount which would be the prevailing market rates i.e.
5.8%. Therefore, the income tax saved here would be the tax rate on the difference between
the market interest rates and bonds interest rates, i.e. 4.75% (5.8% - 1.05%).
So, the table below shows the interest amount saved per year and the tax amount saved per
year and the total of both for the next 5 years.
Figures in millions $
Principal
Interest
Year
1
2
3
4
5

amt.
3000
3000
3000
3000
3000
Total

Amt
135
135
135
135
135
675

Tax

amt

saved
50.193
50.193
50.193
50.193
50.193
250.965

Over and above this amount, an additional amount could be earned on these tax savings if it
is invested in the safest treasury security bonds.
1.3. Accounting benefits for Wells Fargo if the bonds are issued
According to US GAAP, the shares would be convertible only if it reached a share price of
$120. Also, when it is converted the total number of shares converted shown in the balance
sheet would not be 1:10, rather it would be the additional price over 100 multiplied by 10
divided by the current market price. For example, in this case if the price reached 120, then
the total number of additional shares shown in the balance sheet would be:
(120*10 1000)/120 = (1200 100)/120
= 200/120
= 1.67
However, these will only be a book entry but sometimes it is enough to woo shareholders,
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because very few investors look at the notes to accounts and only see the financial statements
on its face value. Hence, many a times this kind of accounting policy is enough to attract
investors.
2. Whether Investors should subscribe to these Bonds issue or not?
Now, looking from the investors point of view, some of the strong reasons for not investing
in these bonds are as follows:
1. The basic assumption that the investor is making here that the stock price is going to
touch $120 in the next 5 years, which means that the company will have to grow at a
CAGR of 20.38%. This scenario looks a lot difficult considering the past two years
CAGR of around 16%.
2. If the investor is of the strong opinion that the stock will reach $120 in the next 5 years,
then there is no point in subscribing for this issue which will be converted at a price of
$77.01. He might as well purchase the shares at todays market price of $47.45 which is
$29.56 cheaper than the conversion price.
It is true, that the investor will be getting an interest rate of 1.05%, but we would
suggest the investor to take that much risk and purchase the share at current market
price.
Now, let us look at the table below which shows the conversion rate & price, the stock
return in % over 5 years and CAGR in % over 5 years, which would justify our
recommendation to the investors to not subscribe for the bond issue:

Stock
Per

Current

Return

Stock

Conversio

share

Market

Differenc

over 5 yrs CAGR

Price
120.00
125.00
130.00

n Rate
15.58
16.70
17.73

price
77.01
74.85
73.32

Price
47.45
47.45
47.45

e
29.56
27.40
25.87

in %
35.83
40.12
43.60

%
9.28
10.80
12.14

135.00
140.00
145.00
149.38

18.69
19.57
20.40
21.07

72.25
71.53
71.09
70.88

47.45
47.45
47.45
47.45

24.80
24.08
23.64
23.43

46.48
48.91
50.97
52.55

13.32
14.37
15.32
16.08

The table below shows the projected returns to the investor at various price points if
they purchase the stock at current market price and hold it for 5 years.
Stock Return over 5 CAGR
Stock Price
120.00
125.00
130.00
135.00
140.00
145.00
149.38
160.00
180.00
200.00
3.

Buy Price
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45

yrs
152.90
163.44
173.97
184.51
195.05
205.58
214.82
237.20
279.35
321.50

%
20.39
21.38
22.33
23.26
24.16
25.03
25.78
27.52
30.56
33.34

Now, even if the investor is keen to invest in the bonds issue then we suggest an
alternate investment strategy for the investor if in case he/she does not want to lose the
interest amount as well.

Let us assume that the investor has $100,000 to invest.

We propose the investor to invest $36,458 in treasury security for 5 years where the
interest rate is 2.88% per annum. By doing this the investor will get $1050 per year as
interest payment which is equivalent to the interest amount had he invested the whole

of $100,000 in those convertible bond.


The remaining amount of $63,542, we would advice to invest in shares of Wells Fargo
directly at the current prevailing market rate of $47.45. The total number of shares that

could be bought with this amount is 1,339.


Now if the share price reaches $120 in a period of 5 years then the returns would be as
follows:
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1. Return from Bonds issue


Total no. of shares allotted is 36.458*15.51 = 568 approx
This would be worth $68,160 after 5 years (364*120).
Total Interest earned over 5 years = $1,050*5
= $5,250
Hence, total return from bonds = Return from shares allotted + returns from
interest
= (68,160 36458) + $5,250
= $36,952.
2. Return from purchase of shares
Total no. of shares purchased = 63,542/47.45
= 1,339
This would be worth $160,680 (1339*120)
Total return after 5 yrs = 160680 - 63542
= $97138.
3. Hence, total return from bonds and share purchase = $36,952 + $97138
= $134,090.
4. Now, had the whole amount of $100,000 been invested in Bonds the return would
be as follows :
Total no. of shares allotted is 100*15.51 = 1551 approx
This would be worth $186,120 after 5 years (364*120).
Total Interest earned over 5 years = $1,050*5
= $5,250
Hence, total return from bonds = Return from shares allotted + returns from
interest = (186,120 100,000) + $5,250
= $91,370.
This shows a difference of $57,280 from our proposed investment. Hence we
propose that even if the investor wants to invest in bonds he/she should follow
our recommendation for additional returns of $57,280.