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What rate do we used in finding the discounting factor of convertible bonds?
Is it the nominal rate? or investor required rate of return?- Topics: 1
- Replies: 87
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The cost of convertible debt/bonds to the INVESTOR is estimated using the IRR method (Internal rate of return). This gives you the INVESTORS required rate of return on the convertible bonds. It is a market based rate of return measure, not a nominal rate of return.
Remember that the calculation is a function of the current MV of the convertible bonds and the nominal annual cash flows (interest BEFORE tax) payable on the bonds + the redemption or conversion value payable on maturity of the bond.
Finally, the required rate of return calculated in this way is an opportunity cost of capital or return, and is a market based rate (based on market values) not a nominal required rate of investor return.
Note, when calculating the required rate of return to the company (cost of convertible debt after tax) you must remember to deduct the tax from the nominal annual cash flows (interest) in your table of cash flows.
Hope this has helped. Kevin Kelly
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