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We are given a 3% convertible loan notes which are redeemable in five years’ time at their nominal value of $100 per loan note. Alternatively, each loan note can be converted in five years’ time into 25 ordinary shares. The current share price is $3·60 per share and future share price growth is expected to be 5% per year. The before-tax cost of debt of these loan notes is 10% and corporation tax is 30%.
I don’t understand the reason why the final answer is using 10% (Pre-tax cost of debt) instead of (Post-tax cost of debt)????
The question asks for the market value of the loan note.
It is investors who determine the market value and they do not get the benefit of tax relief. We discount their receipts at their required rate of return, which is the same as the pre-tax cost of debt.I do suggest that you watch my lecture because I make this point clearly (and it is something regularly asked in the exam). The lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
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