Corporation tax – Convertible notes

Dear John,

After reviewing your response to Keke’s – “more clarification needed” question

I am confused as to when we need to use the after tax figure for calculations?

Is it not relevant in this example because it is corporation tax?

Please advise on when we use after tax figure and when not to as in your example below?

Keke:

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).

Many thanks John