- 10 Marks
FR – L2 – Q56 – Financial Instruments
Question
Tafu Ltd issued GH¢10 million of 4% convertible loan notes on 1 October 20X3, on which interest is paid annually in arrears on 30 September. The loan notes are convertible into equity shares of Tafu Ltd on 30 September 20X6 at the rate of 20 shares in Tafu Ltd for every GH¢100 of notes. Alternatively, the notes can be redeemed on that date for cash at par, at the option of the note holder.
If Tafu Ltd had issued straight loan notes, redeemable at par after 3 years, it would have had to pay interest at the rate of 7% in order to persuade investors to subscribe for them.
Required:
(a) Show how the convertible loan notes would be accounted for in the financial statements of Tafu Ltd for the year to 30 September 20X4.
(b) Comment on the validity of the reasons of the directors for choosing to issue convertible loan notes.
Answer
(a). In the financial statements of Tafu Ltd for the year to 30 September 20X4:
In the statement of profit or loss, the finance cost relating to the loan notes is GH¢640,000.
In the statement of financial position:
Non-current liability for the loan notes = GH¢9,384,000
Equity component of loan notes = GH¢856,000.
Workings: GH¢10 million of loan notes
| Year | Cash flows | Annual cash flow | Discount factor at 7% | Present value |
|---|---|---|---|---|
| GH¢’000 | GH¢’000 | |||
| 1 | Interest | 400 | 0.93 | 372 |
| 2 | Interest | 400 | 0.87 | 348 |
| 3 | Interest + Redemption | 10,400 | 0.81 | 8,424 |
| Value as straight loan notes | 9,144 | |||
| Issue price | 10,000 | |||
| Equity component (residual amount) | 856 |
Finance cost: year to 30 September 20X4
GH¢’000
Total finance cost: 9,144 × 7% = 640
Interest payable on 30 September 20X4 (GH¢10 million × 4%) = 400
Accrual to add to carrying amount of debt = 240
Carrying amount of loan notes: 30 September 20X4
Initial valuation of debt element = 9,144
Add accrued interest = 240
Carrying amount at 30 September 20X4 = 9,384
(b). The directors are not fully correct in their views. If the company had issued straight convertible loan notes, the interest cost would be 7% per year or GH¢700,000. By issuing convertible loan notes, the total finance cost is not much lower in the first year (GH¢640,000) and it will increase in the next two years as the liability for the loan notes increases.
The company’s gearing will be reduced after three years if the loan note holders exercise their option to convert their notes into equity shares. In the short term, however, the issue of the convertible loan notes will add to debt capital and only a small amount to equity (the residual amount); therefore, it seems likely that gearing will increase in the short term and will not fall.
- Tags: Convertible Loan Notes, Financial instruments, Gearing, IAS 32
- Level: Level 2
- Uploader: Samuel Duah