FMAnother on convertibles :(

pastymuncher, i read your post in 'struggling with f9' post...ok, this is where the problem is... you must know the basics...
when redeemable debt is in question, we use IRR, and for that we need to use 2 different discount rates, one will give you negative NPV and the other one will give you positive NPV. IRR is where the NPV is zero. no profit no loss.

"Convertible" bond works exactly the same as a straight bond, except for 1 complication.

What is the same: you use IRR to calculate the required return of the bond holder.

What is different: you need to decide if the bond holder will redeem or convert--this only affects (a) the number of years, and (b) the terminal amount.

Your example:
Will bond holder redeem or convert?
a) redeem: you get $100 in 3 years
b) convert: you get 30 shares in 3 years.
What is better?

Test the value of 30 shares in 3 years to answer the question:
1 share will be worth 3.80 * (1.04^3) = 4.27

You get 30 shares: 30 * 4.27 = 128.23
128.23 > 100.00 so the bond holder will convert.

Now you set up your IRR Table with the 128.23 as the value in year 3, and do the IRR

Year 0: 92
Years 1-3: 9 (minus tax shield)
Year 3: 128.23 (not 100, as you would if it were a straight bond)

I'm an idiot, of course you have to calculate IRR. Like I said in the previous post, I'm so close but so far. I need to join some of my thinking up. One week to make it click......

Thanks guys.