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Dear John :
Could you please explain how the examiner has calculated the market value after conversation in Section B question # 18 (Specimen Exam from Sep 2016) ?
His answer : market value of each loan note = (8 *5.033 )+(126.15*0.547)=$109.26
My assumptions :
0.547 is PV discount factor of 9% 7 years. Annuity factor is 5.033.Again, 8 means number of the ordinary shares per one loan note after 7 year . )
Market value of debt (8% convertable loan) = PV of the cash flows associated with debt.
Why number of ordinary shares 8 was multipled by annuity 5.033 ?
Why conversation value was as 126.15 and discounted back by 0.547?
Nominal value of debt is not taken into account ?
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The market value has been calculated for 1 loan note with a nominal value of $100. (This is what we would normally calculate when asked this, and the choice of answers makes it clear that this is what was wanted.
I assume that you have watched the lectures, and so you will know that the market value is the present value of the expected receipts.
The expected receipts of $100 nominal are:
Interest of $8 per year (8% x $100) for years 1 to 7
and
conversion worth $126.15 (they would choose to convert because this is more than $100) in 7 years time.The interest for each of 7 years is discounted using the annuity factor. The conversion in 7 years time is discounted using the normal PV factor.
Hi John, On this same questions why is the pre-tax cost od debt used and not the after-tax cost of debt?
As I stress in my lectures, it is the investors required rate of return that determines the market value of debt, and that is pre-tax because the investors are not affected by company tax.
The post tax cost of debt is only relevant when looking at the cost of debt to the company.
Do watch the free lectures. They are a complete free course for Paper FM and cover everything needed to be able to pass the exam well.
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