Massey Coal (a fictional company) just issued $50 million of convertible notes. Each note has a $1,000 face value, has 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.

Required:

1. Why were investors willing to pay $50 million for Massey’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.

3. Which interest rate—2% or 12%—would be used to compute Massey Coal’s interest expense under U.S. GAAP, assuming cash settlement of conversion is not permitted. Which interest rate would be used under IFRS guidance?