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ACCA Applied Skills · Financial Management · The valuation of debt and other financial assets

Kiln Co has a $100 convertible bond that can be redeemed at par or converted into 40 shares in 3 years. The current share price is $2.50, expected to grow at 4% a year. Which statement is correct about the terminal value to be used when estimating the bond's cost to the issuer?

Holders will convert, and the terminal value is $112.49. The share price grows to about $2.812 in three years, so 40 shares are worth $112.49. That is more than the $100 redemption value, so conversion is the better choice for holders.

  1. AHolders will convert, so the terminal value is $112.49Correct
  2. BHolders will redeem, so the terminal value is $100.00
  3. CHolders will convert, so the terminal value is $100.00
  4. DHolders will redeem, so the terminal value is $112.49

Explanation

Future share price = 2.50 × 1.04^3 = $2.812. Conversion value = 2.812 × 40 = $112.49. This exceeds the $100 redemption value, so a rational holder converts. The higher of the two values is used as the final cash flow.

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