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Donald Co has 8% convertible loan notes in issue which are redeemable in five years’ time at their nominal value of $100 per loan note. Alternatively, each loan note could be converted after five years into 60 equity shares with a nominal value of $1 each.
The equity shares of Donald Co are currently trading at $1.25 per share and this share price is expected to grow by 4% per year. The yield to maturity (before-tax cost of debt) of the loan notes is 10%
What is the current market value of each loan note (to the nearest $)?
The answer is;
Forecast conversion value after five years $1.25 × 1.045 × 60 = $91.25 and hence the investor will choose redemption.Value of loan notes = (8 × 3.791) + (100.00 × 0.621) = $92.43 or $92.
The correct answer is: $92
So what does ‘1.045’ in the equation for the conversion value stand for? How is it computed? Lastly, the question here clearly states that each loan note could be converted into 60 shares at a nominal value of $1 each. Why $1.25 is multiplied here to get the conversion value? Shouldn’t it be $1 each instead? I just think this question is riddled with errors. FYI this is from ACCA getting ready module.
It is not 1.045, it is 1.04^5 (5 years growth at 4% per year).
The conversion value is calculated on the market value, not on the nominal value.
Have you watched my free lectures on this?
thank you John. I haven’t watched it. I finished FM myself and was wondering what it means. It seems like ACCA getting ready modules are not made in that perfect manner in that they simply omitted square root for 1.04^5
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