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Convertible Debt

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Massey Coal just issued $50 million of convertible notes. Each note has a $1,000 face value, a stated interest rate of 2%, and matures in five years from the issue date. Investors have the option of holding each note to maturity or converting the note into 100 shares of Massey Coal common stock. Conversion is not permitted during the first two years after the issue date. The company received $50 million cash from investors when the convertible notes were issued.
1. Why were investors willing to pay $50 million for Masse's debt when the promised interest rate is only 2%?
2. Several analysts claim that Massey's incremental borrowing rate for a similar five-year note without the conversion option is 12%. Describe how analysts might have arrived at this borrowing rate from information typically found in a company's financial statements and notes.

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Step 1:
The investors are willing to pay $50 million for Masse's debt when the promised interest rate is only 2% because the convertible note gives the option of converting into 100 shares of Massey Energy Co. common stock two years after the date of issue because the current market price of Massey Coal stocks is high.

The current price of common stock of Massey Energy Co. at the NYSE is $65.14. If we consider 100 shares of common stock, it means a value of $6514. Currently the ...

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