AFMP4
Syllabus B3cd. The Cost of CapitalCost of debt

# Convertible Debt 3 / 4

### Convertible Debt

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:

1. Cash payable

2. Future share payable

#### Illustration

8% Convertible debt. Redeemable in 5 years at:
20 shares per loan note (current MV 4 and expected to grow at 7%)

The MV is currently 85.

Tax 30%.

 Time Cash 5% PV 10% PV 1-5 Interest 5.6 4.329 24.24 3.791 21.23 5 Capital 112.2 0.784 87.96 0.621 69.68 MV -85 -85 27.2 5.91

IRR = L + (NPV L / (NPV L - NPV H)) x (H - L)

IRR = 5 + (27.2 / (27.2 - 5.91)) x  (10-5) = 11.4%

Note :

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

#### Terminology

• Floor Value MV without conversion option (basically the above calculation using cash as capital)

• Conversion Premium MV of loan - convertible shares @ today’s price