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The cost of capital

Question 14

Cost of convertible debt

A company has in issue 4% convertible loan notes which are due to be
redeemed in 4 years at a premium of 10%. Alternatively the investor can
choose to convert the loan notes into 5 ordinary shares in 4 years’ time. The
current market value of the loan notes is $90 ex interest.

The company’s ordinary shares are currently worth $20.50 each with the share
price being expected to grow at a constant rate of 3% per annum. The rate of
corporation tax is 30%.

Calculate the cost of debt to the company (post-tax cost of debt).

4
Anticipated share value in 4 years: $20.50 × 1.03 = $23.07 each.
Value of 5 shares at conversion date: $23.07 × 5 = $115.35

Value of redemption option = $100 × 1.1 = $110

Assume investor would choose to convert.

Cost of debt to the company (use post-tax interest value)

Time cash flow d.f/a.f 5% PV d.f/a.f 10% PV

t0 £(90.00) 1 $(90.00) 1 $(90.00)

t1-4 $2.80 3.546 $9.93 3.170 $8.88

t4 $115.35 0.823 $94.93 0.683 $78.78

NPV $14.86 NPV $(2.34)

IRR = 5 + [$14.86/($14.86 – $(2.34))] × (10 – 5)

IRR = 5 + 0.864 × 5 = 9.3%

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