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Please refer to this question which I asked earlier:
Lane Co has in issue 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 Lane Co ordinary shares.
The current share price of Lane Co 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%.
What is the current market value of a Lane Co convertible loan note?
A. $82.71
B. $73.47
C. $67.26
D. $94.20
Your answer:
Keymaster
You need first of all to decide whether the holders of the loan notes expect they will convert or not.
They will expect to take the higher of cash of $100 or shares worth 25 x $3.60 x 1.05^5.Then to get the market value, you discount the expected receipts at the investors required rate of return, which is 10%. (Tax is not relevant because the investors are not affected by company tax – tax is only relevant when calculating cost of debt to the company).
The expected receipts on $100 are interest of $3 per year for 5 years, and the amount on redemption as described above.
All of this is covered in my free lectures – the lectures are a complete free course for Paper F9 and cover everything needed to be able to pass the exam well.
Extract from ACCA answer:
Discounting at 10%, loan note value= (3 x 3.791) + (114.87 x 0.621) = $82.71Can you please tell me where 3.791 and 0.621 is derived from?
In the exam, you are provided with 2 tables, one that says Present value Table , and one that says Annuity table. Since we are talking about a 3% bond, this means that it yields $3 per year for 5 years and on the fifth year, a redemption value. The coupon is considered an annuity, thus you need to go to the Annuity table and locate the discount rate or cost od debt (10% in your case). Then you also need to locate the time period (n=5 years in your case). 10% for n=5 years gives 3,791. Now, having found the redemption value (114,87), you similarly discount it to the present but this time you use the Present value table and NOT the Annuity table. 10% cost of debt for n=5 on the Present value table gives 0,621.
I hope this was helpful 🙂
delamanisp: No problem 🙂
deke: the answer from delamanisp is correct. The discounting is the most basic technique of all in Paper F9 (and is revision from Paper F2) – there will never be an exam which does not require you to be able to use the discount table provided, in many of the questions.
You really should watch my free lectures (and if necessary the relevant Paper F2 lectures).
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