ACCA · Question 12 · Estimating the Cost of Capital
Section A
AlphaTech PLC has $5 million of convertible bonds in issue. The bonds pay an annual coupon of 6% and are redeemable in 4 years at par, or convertible into 20 ordinary shares per $100 bond. The current share price is $4.50 and is expected to grow at 5% per year. The pre-tax cost of debt is 8% and the corporate tax rate is 25%.
When calculating the Weighted Average Cost of Capital (WACC), how should the cost of this convertible debt be determined?
Answer options:
Use the current yield of 6% multiplied by (1 - 0.25).
Calculate the Internal Rate of Return (IRR) using the higher of the redemption value or the expected conversion value in 4 years.
Treat the convertible bonds entirely as equity since they are likely to be converted.
Use the pre-tax cost of debt (8%) without tax adjustment, as conversion avoids tax shields.
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