Boston Chicken Inc.

: 4 ½ % Convertible
Subordinated Debentures Due 2004
Case Background
Boston Chicken announced it would issue $130 million dollars in convertible subordinated
debentures yielding 4.5% priced at par in January of 1994. It had only recently gone public in
late 1993, and this made analysts skeptical of what the company was doing.
Boston Chicken was a franchisee food service company that specialized in complete meals
featuring rotisserie-roasted chicken. The company combined fresh meals with home cooking
and convenience. It wanted to become leader in the segment it was in – fresh food service. In
January of 1993, it had 228 stores of which 40 were company operated stores and the rest
franchisees. The company was to open 765 more stores in the next three years, and there were
to be 450 stores by the end of 1994.
While the initial phase of store expansion had been funded with loans and equity investments
of $38 million, there was more needed. In its initial public offering, it raised about $60
million in proceeds which were directed towards store expansion.
Thus in 1994, it was aiming at raising the $130 million to finance expansion. The earlier IPO
had shown a 143% gain in one day since the initial stock price of $20,00 was underpriced and
by the end of the day it rose to $48.50. This was criticized by analysts as they believed the
stock had been underpriced by the Investment Bank looking into the deal. However, Boston
Chicken were happy with the pricing and the evaluation, which they would be given the
profit they realized in one day.
Now when the convertible bonds were about to be issued, analysts were wondering if the
bond would similarly be underpriced or whether they would be fairly valued. The offering
had attracted the attention of Martha Lovejoy, senior vice president of Growth and Income
Fund, of Allegiance Group. 5% of it’s $8 billion fund was dedicated to convertible bonds.
Along with a new associate at Allegiance, she was to decide some details about the offering
and see if it would be worth investing in the bonds.

Financial Problems
There are a number of problems in the valuation of the bonds. These largely revolve around
the fact that there are multiple types of bonds i.e these bonds have various different features.
A convertible bond for example is valued differently from a straight (non-convertible) bond.
Analytical ratios on Comparable Convertible Bonds
There are ratios like Conversion Ratio, Market Conversion Price, Market Conversion Ratio
which each have some significance in how a bond is priced. The problem here is the
interpretation of these in relation to other bonds. For example, what would a high Market
Conversion Premium ratio signify? Some bonds have very similar Premium Payback periods
despite having very different yield-to-maturity rates. This changes how the bond will be
entertained by the market, so it is important to make sense of these details. There are also
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additional questions like how can a low yield bond have a bad rating from an agency like a
CCC+ or have a yield which is twice that of the comparable CCC bonds. Thus market factors
need to be understood, to evaluate why bonds are given certain ratings.
Pricing And Yields for Converts and Straights
Another issue was why normal bonds were priced differently from convertible bonds. This
would have to do with the convertibility option which would potentially dilute shares. This
would have to be analyzed in greater detail
Raising Money from Convertible Debt versus Secondary Offering
A Bloomberg analyst makes a statement that Boston Chicken would want to raise money
from a convertible debt rather than a secondary offering in the stock market of common
stock. The reason given is because it is less expensive and won’t dilute the shares. But this
may not be the case since a convertible bond if converted will then dilute shares.
Bond rating at CCC+
The bond has been rated by agencies at around a CCC+ rating which is close to a default
rating, not even putting it in an investment grade scenario. The YTM of such bonds is around
13% whereas the bond is itself offering a YTM at 4.5%. The question arises with the
company targeting expansion, and doing so well, what is the reason for such a poor rating by
all the agencies. What aspects of the company makes rating agencies believe that the
payments on the bond will not happen?
Volatility Assumption
There is a conversion option mentioned in the bond which will convert the bond into about
2,324,400 new shares if the bond was converted immediately. This would essentially dilute
the stock price. To price such a bond, there is a need for an estimate of volatility. Using
limited data of about 66 days of trading information Pao had estimated the volatility to be
quite high – 0.666. This however had certain problems – it was a very short observation
period and since the IPO was very recent the volatility of the share was expected to remain
high in the short-term since the market was still responding to it and learning it’s fair price.
The solution to finding a volatility for the bond is to choose its competitors and check their
volatility. The reason this works is because, over the long term all comparable firms tend to
have very similar volatility. However, junk bonds have volatility of 15 to 20% while the
current bond had a volatility of 32.3%. This was much more volatile an option than regular
junk bonds and there was a need to understand why.
Value of the Conversion Option
The conversion option of the bond would have a separate value to it. The option itself (a call
option) would convert to 17.88 shares. The option would also probably be utilized since it’s
strike price $55.938 and the share was already trading at $44.75. The issue here is how to
value the convertible part of this bond. What it represents is two things – the option to
convert low risk debt to much higher risk equity and a more flexible bond in the eyes of the
market but with a higher risk premium since one has to wait until the bond gets “in the
money”. We will analyze how much the option is worth later.

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Likelihood of conversion by 1996
Another problem is now to understand whether or not conversion of the bond will happen.
The company is expected to grow very quickly, with a forecast of 50% growth rate over the
next couple years. Even Merill Lynch has forecasted the firm’s annual growth rate in E.P.S as
40%. IF this is true, then the option to convert will come much before the 10-year maturity
period. Lovejoy had estimated that the option would be valuable or “in the money” once the
value of the company’s assets crossed $1.26 billion. But the problem here is that there was no
estimate on how long it would take to get to this point. If the company were to experience
such a high growth rate, then it was possible the conversion would happen at or before 1996.
The estimation of growth rate would clear up whether this was something to be considered,
since this would drastically change the valuation of the bond to Lovejoy.
Valuation of Redemption Option
The terms of the bond also allowed the company to call the bond before maturity. This was a
risky option for any investor since this meant that if interest rates rose, then the company
could buy back the bond and reissue it at a profit. This would be forceful buy back leaving
the investor worse off. Since the bond has become riskier, the yield would have to go up and
the bond value or price would have to go down. A straight bond would be a better option.
However, in this case the redemption of the bond would mean the bond would be forcefully
converted into common stock. This would also occur when the bond would be in the money.
Recommending Boston Chicken’s Bond
We now value the bond by summing up the different parts of the bond. There is a straight
portion of the bond that we know has already been valued at par of $1000. However, there
are two options to the bond that need to be valued. The first is a conversion option which will
allow the bond to become a certain number of common stock shares and the other is a
redeemable option which is essentially a call option for the issuer. While the conversion
option raises the bond price, the redeemable option will depress it. This will determine
whether buying the bond at the quoted price makes sense or if there should be some long
term game plan in mind when purchasing it.

Analysis
We now analyse each problem to understand how to value the bond so that Lovejoy can
figure out if it’s a good option to buy it.
Analytical ratios on Comparable Convertible Bonds
The analytical ratios in the table of Exhibit 3 are quite interesting. All bonds shown have a
roughly CCC rating. However, the first striking thing is their yield-to-maturity rates which
wildly vary from as low as 1.71% to as high as 24.81%. We note from exhibit 4, that the
average CCC rated bond produces a yield of 13.40%. Only Datapoint 8 7/8s are giving a
yield in that range.
Yield-to-maturities are the rate at which all cash flows are discounted to reach the price of the
bond. We note that bonds of Adv. Medical have been quite devalued to the point that the
price is only $400. This is a risky investment from its rating and thus is priced much lower
than the others. However, there are anomalies here since, despite being junk grade
investments there are bonds which are giving very low yields. This represents a high risk low
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yield bond. When bonds have a lower YTM than their yield as is the case with Orbital and
Cellular Comm, it’s because they are being traded at a premium. This is because the market
values it as worth more than what the original bond was at par value. The other two bonds are
being traded at a discount since their YTM is higher than their yield.
Conversion ratio is the number of shares to be received in exchange for 1000 dollars – in this
case Boston Chicken despite being a CCC grade bond has a much higher value than all other
companies, since the number of shares $1,000 can buy is lower than others. This means that
the market values it’s share quite well. Even the two bongs trading at premiums do not have
such a good Conversion ratio. This is something in favour of Boston Chicken and perhaps
warrants a premium since the market strongly favours its success. This also makes the CCC
rating questionable.
The Market Conversion price also essentially tells us that the bond is more expensive than
equity, since the equivalent equity the bond could buy is $56 while the current share price is
$45. This premium on the share can be recovered in 4.5 years so the bond seems to be one
which must be held for at least 5 years to be more valuable than equity. Early pull-out would
be inadvisable.
Overall the bond seems to be of good quality and it makes the CCC rating questionable.
Pricing And Yields for Converts and Straights
A convert bond is a value add to any investor. The option given is to “call” the bond i.e trade
it in for some shares. Thus the value of the bond rises with the increasing stock price, making
it more valuable to investors and thus the coupon can be lower. Since convertible bonds are at
the end of the day bonds, they will pay out a coupon regardless of what happens to the
company as long as it is solvent. So the downside risk of buying a convertible bond is also
much lower than that of common stock. This means that downside is protected – there is an
assured payoff any investor will get if the company is still operating even if the shares
performs badly. This makes it an attractive security and thus can be sold at a lower yield.
However, the only issue is that convertible bonds have a lower priority in bankruptcy claims.
So this will depress the price a little, since straight bondholders will be paid before converts.
Raising Money from Convertible Debt versus Secondary Offering
While it is true that issuing debt is cheaper for a company than equity, it is not true that
issuing of this bond won’t dilute shares. The convertible bond has the option to dilute shares
and the potential to be exercised is quite high given that the financial performance of Boston
Chicken has been strong in the past. The company is also financing for a specific purpose –
capital expenditure aimed at expansion. If this is the case then clearly there is a game plan in
mind for the company, and they will invest strategically to get greater rewards for their
shareholders. In this case the value of the share price will increase, putting the convertible
bonds “in the money”. If the option is exercised there will be dilution of equity. The case that
can be made here is that, if the time scale of expansion is slow and/or investor response to the
stock is slow such that the share price only gradually rises, then the value of the bond which
will convert to share will be low, meaning that the number of shares that will dilute the
outstanding shares will also be low. This in effect will not dilute share price by much. But it
is likely that the option will be exercised by some investor or the other. Thus the Bloomberg
quotation is wrong.

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Bond rating at CCC+
Looking at the Financial Statements of Boston Chicken in Exhibit 2 gives some
understanding of the company which may answer the question of why there was such a low
rating issued. CCC+ is a junk bond rating. There are 6 rating grades above CCC+ above
which the bond would be investment grade, those 6 being speculative grade. Clearly the
reason for this must be the lack of faith in the management of the company to be able to
regularly pay the coupon on the $130 Million.
4.5% of $130 million gives a yearly outflow of $5.85 Million as a coupon payment. At
current revenue levels in 1993, that is about 20% of the revenues generated in the year. That
is a very large cash outflow compared to the inflow that is occurring which may not even be
hard cash.
We also notice that from 1989 to 1992 the firm has not turned a profit. Revenue figures were
very small for a long time, growing at barely 50% a year compounded annually but this has
suddenly increased 300% in the last year. In the years preceding the stock issue the
operations of the company had been abysmal, and there is a cumulative loss of about $10,750
million that has to be wiped off the books by new profits.
We can also notice that given the 300% increase in revenue the profit is only 1.3% of the
revenue generated. This margin is ridiculous from a fast food restaurant which has just gone
public, and there is not a very good sign for investors about the efficiency of the company.
From system wide revenue found in store data, it can be argued that revenue increases
proportionally to the number of stores. However, with the operations being as poor as they
are, any expansion will only proportionally increase revenue but income will not improve that
much.
When operations are so poor and there is such a large loss to wipe clean, it is likely that the
ratings agencies were not convinced of Boston Chicken’s decision to rapidly expand into new
markets by opening up new stores. If there is some improvement in the financials of the
company regarding income and cash flows then ratings would automatically improve.
Volatility Assumption
Exhibit 5 shows us a number of different companies and their volatility, each of these
companies being possible competitors to Boston Chicken. The problem with whatever data
we currently have about Boston Chicken is that it is too short term – 66 days data is not
enough to calculate the volatility of the stock. In fact, since it is early days in the trading of
the stock, such a high volatility is to be expected. And the huge price jump on the first day of
trading would definitely lend an outlier effect to the volatility calculation.
To take care of this we have to figure out what parameters closely define Boston Chicken and
then seek out a competitor and assume it’s volatility will be the same as the firms. The issue
here is the kind of parameters to look at. Now we know that the net margin of Boston
Chicken is quite low, but this is an initial estimate since the company has just started turning
a profit.
It is expected that with increased number of stores and increased synergies from running
these stores, profit margins will increase. If there is only modest growth in the profit margins,
we can assume that it will be very close to Morrison Restaurants. This has 426 outlets

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(similar to Boston Chickens eventual estimate of 450 outlets in total after financing) and it’s
profit margin is 3.5%.
We can assume it’s volatility of 0.32.
Value of the Conversion Option
The value of any conversion option is the value of the conversion premium over that of the
straight bond. The conversion option is relatively easy to calculate once certain ratios are
obtained as they have been in Exhibit 3. The conversion ratio is given at 17.88 and the
current share price is $44.75. Thus the conversion value is roughly $800.
Likelihood of conversion by 1996
Conversion of the bond has been estimated to occur at market conversion price. This can also
be considered to be the strike price which is $55.938. The current stock price is $44.75. This
represents a growth of 25% over the current stock price.
Now the current revenue of $20,241 million the EPS is $0.04 (Exhibit 2) and the growth rate
estimate is said to be about 50%. If this is true, revenue will be roughly $45,000 million in
1996. At a slightly higher profit margin of 2% that would mean profit would touch $910
million. This would mean a EPS of about $0.13.
If on the other hand, we take Merill Lynch’s estimate of a 1994 EPS of $0.40 and the growth
rate to be 40% then EPS will be $0.78. Depending on which forecast one would like to take
the likelihood of conversion will vary drastically.
The first version is too drastic to be believable, so we take the second option which shows a
growth of about 40%. If we assume that the stock price will also grow at the same rate then
the stock will be worth around $63. This puts it “in the money” making conversion very
likely in 1996.
Valuation of Redemption Option
Finally, we come to valuing the redemption option of the bond. The redemption option in this
case is an option given to the owners of the company to issue shares if and when they deem
fit, and use the value of the bond at that time to finance this issue. This is typically not what a
redemption option looks like, so the name is a little misleading. Usually redeemed bonds are
paid back using cash but not in this case.
Since this option is offered to the owners of the company it reduces the value to the
bondholder. If interest rates decline, the issuer could buy the bonds at below market value.
This would like to be avoided by the bondholders.
The bond has a protection period of 2 years after which the bond is callable only at 140% of
the exercise price, after which roughly at around 103% for 6 years. This breakup alters how
the bond should be priced, and thus the methods used to value it would have to be building a
tree of the different ways in which it would be redeemed (or called) and then an average
could be taken.
However, conducting such a valuation is computationally intensive and no online framework
exists to value it. There are two possible states that the valuation could be – either greater
than or less than $800.

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Recommendation
Now that we have valued all the parts of the bond and gone over the details of how it will
appear to investors we can come up with a recommendation on its purchase. The bond can
be split up into three parts – straight bond, conversion option and redeemable (callable)
option.
The straight bond is valued at $1000 and the conversion option at $800. The redeemable
option is valued using methods which are difficult to use given the data. We assume for this
case that the value of the redeemable option will be less than $800.
In this case the final value of the bond is $1000 + $800 – redeemable value = $1000 + delta.
This delta value would depend on the value of the redeemable option. Assuming delta is
positive we can now say that the bond is priced at a premium and will be valued as higher
than $1000 by the market. In this case, the YTM of the bond will be lower than 4.5% which is
the yield of the bond. The volatility of the bond is around the average volatility of similar
bonds so this does not drastically affect the valuation. The premium means that there will
be low capital gain with this bond but in the short term the cash inflows from the coupon
are valuable.
The data shows that conversion option will probably be applicable by 1996, with a high
likelihood. This means that the bond can be converted for stock in 1996 which may dilute
share price, but there will be a balance since debt will be converted to equity rather than a
fresh equity being issued.
All things considered, buying the bond would be a good option since the conversion option
is very attractive. In fact, due to the redeemable option which is set to go off after 2 years
but only if the price touches $78 (140% of $55.94) there are two good effects that make this
attractive.
One the expected growth over 2 years is not as high as $78, it would touch around $63 by
the time it becomes “in the money” in 2 years. This means that the conversion option
benefitting the bondholder will kick in before the redemption option.
Secondly, the redemption option depresses the bond value. With the conversion option
alone the bond would be priced much higher, 80% higher. The redemption option offsets
this price since it depresses bond price.
Thus it would be a good option for Lovejoy to buy the bond.

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Section B