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Hi there,
In the question it says ‘Share prices rises at an average of 6%. Convertible Shares are redeemed at par in 8 years or converted in 6 years time into 15 shares per $100 bond.On the answer sheet, Convertible debt:- 5.50 * (1.06)6= $7.80 * 20 shares= $117.00 per bond
Using linear interpolation, after tax cost of debt – answer is 6%
Conversion appears likely, as conversion is higher than par.
But it also states that -‘We can confirm that the conversion is likely and implied by the current market price of €107.11(market value of convertible debt given in the question) by noting that the floor value of the convertible debt at an after tax cost debt of 6%How do you know if the bonds are converted or redeemed, Is it the the highest present value which determines whether is gona be redeemed or converted and at 6 years or 8 years?
In relation to Asset beta formula; would it be right to say
First you ungear by using( the formula ; Ba= VE/VE + VD(1-t) *Be
(using a proxy company)Then you re-gear, use the asset beta figure for the actual company with its own debt and equity market values.
But this is a reverse of the above formula ? Ba= VE + VD/Ve * Be
In some of the questions i have practised, in the part where you re-gear, the formula is not reversed? Why is that?
Would greatly appreciate your help.
With regard to your first question, the market value depends on what the investors expect will happen.
At the moment, they expect that they will choose to convert (because they expect that the shares will be worth more than the cash) and so the market value is bases on their expectations.(Maybe in the future things will change and they will change what they expect to do – this will therefore change the market value of the debt – but at present all we are concerned about is what they are expecting at present.)
With regard to the asset beat formula, what you say is correct.
You say that in some questions they have not reversed the formula – in this case, either the answer is wrong or you have misunderstood something in the question/answer.
Your understanding is completely correct 🙂Hi John,
Thank you for your reply.So it is the expected market value of the shares at conversion or par value(cash value) which determine what the shareholders will do.
But where does the redemption bit come in?
And what does the following bit mean :-But it also states that -’We can confirm that the conversion is likely and implied by the current market price of €107.11(market value of convertible debt given in the question) by noting that the floor value of the convertible debt at an after tax cost debt of 6%
In relation to the asset beta, the question i was referring to was Fleet company Question 46 (in Kaplan revision kit), it has two subsidary companies and was thinking of investing in one of the projects. (i’m not sure if you have the question to hand but i will post it seperately if you don’t)
Thank you so much
It is not the shareholders that matter – it is the investors in the bonds.
They do not have to decide whether or not to take shares or cash until the time comes.
However, the price they are prepared to pay for the bond now (the market value) is the present value of what they expect they will receive (including what they currently expect they will do with regard to taking shares of cash).
At present they expect that they will take shares (because it will give them more than if they take cash). So the current market value of the bond is based on that expectation (the present value of the future expected receipts).
With regard to the asset beta, I do have a Kaplan Exam Kit, but it does not have a question Fleet. Maybe you are using an old Exam Kit?
Thank you for your prompt reply, It is much clearer now.
In relation to the question, i am using a 2010 edition exam kit.
I am glad it is clearer. With regard to Fleet, I do not have the 2010 edition.
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