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Chapter 20

Question 12

Convertible debt valuation

A company has issued 9% redeemable loan notes with 6 years to redemption,
which would be at a premium of 5%. Alternatively investors have the option of
converting their debt in 6 years to 20 ordinary shares. Investors require a return
of 14%. The current share price is $4.25 and the value is expected to grow at a
rate of 7% per annum.

Calculate the market value of the loan notes.

Calculate also the floor value and the conversion premium.

Expected share value on conversion date:

6
$4.25 × 1.07 = $6.38 each.
Value of 20 shares = $6.38 × 20 = $127.60

Share value is higher than redemption value of $105, so assume loan notes will
be converted.

At current MV, PV of future cash flows from ownership of the debt will equal the
market price:

df/af 14% PV
$
t0 (P0 value) (?) 1 (93.19)
t1-6 Interest 9 3.889 35.00
t6 Redemption value 127.60 0.456 58.19

NPV 0.00
Current market value is $93.19

Floor value = market value without the conversion option.

Floor value = $9 × 3.889 + $105 × 0.456 = $82.88

Conversion premium = market value of loan note – current conversion value of
shares

Conversion premium = $93.19 – 20 × $4.25 = $8.19 or $0.41 per share

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