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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
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.
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