Here the investor has the choice to either be paid in cash or take shares from the company.
Hence, the debt is convertible into shares.
To calculate the cost of capital here, simply follow the same rules as for redeemable debt (an IRR calculation).
The only difference is that the ‘capital’ figure is the higher of:
Future share payable
8% Convertible debt. Redeemable in 5 years at:
Cash 5% premium or
20 shares per loan note (current MV 4 and expected to grow at 7%)
The MV is currently 85.
IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)
IRR = 5 + (27.2 / (27.2 - 5.91)) x (10-5) = 11.4%
Interest = 100 x 8% x 70% (tax adj) = 5.6
Capital = higher of 100 x 1.05% (premium) = 105 and 20 x 4 x 1.07 power 5 = 112.2
Floor Value MV without conversion option (basically the above calculation using cash as capital)
Conversion Premium MV of loan - convertible shares @ today’s price