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Plam Co (March 2016 – Amended)

The directors of Plam Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the company’s debt finance. The dollar is the domestic currency of Plam Co. The company has a number of different kinds of debt finance, as follows:

 Loan notes Loan notes Bank loan Overdraft Denomination Dollar Peso Dollar Dollar Nominal value $20m 300m pesos$4m $3m Interest rate 7% per year 10% per year 8% per year 10% per year Interest type Fixed rate Fixed rate Variable rate Variable rate Interest due 6 months’ time 6 months’ time 6 months’ time monthly Redemption 8 years’ time at nominal value 8 years’ time at nominal value Instalments Continuing at current level The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country. The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year. The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment. Relevant exchange rates are as follows:  Offer Bid Spot rate (pesos/$) 58.335 58.345 Six-month forward rate (pesos/$) 56.585 56.597 Plam Co can place pesos on deposit at 3% per year and borrow dollars at 10% per year. The company has no cash available for hedging purposes. Required: A. Evaluate the risk faced by Plam Co on its peso-denominated interest payment in six months’ time and advise how this risk might be hedged. B. Identify and discuss the different kinds of interest rate risk faced by Plam Co. C. The dollar denominated loan notes each have a nominal value of$1,000 and are convertible. As an alternative to redemption in eight years the loan note holders could after seven years convert each loan note into 110 ordinary shares of Plam Co. The ordinary shares of Plam Co are currently trading at \$6.50 per share on an exdividend basis. The current cost of debt of the convertible loan notes is 8%.

Required:

Justifying any assumptions which you make, calculate the current market value of the loan notes of Plam Co, using future share price increases of:

• 4% per year
• 6% per year.

D. Discuss the limitations of the dividend growth model as a way of valuing the ordinary shares of a company.