- 5 Marks
FR – L2 – Q58 – Financial Instruments
Question
On 1 October 20X3 Bolgania Ltd issued GH¢10 million 6% convertible loan stock on the following terms:
The issue price was at par.
The loan stock is convertible into the company’s equity shares at the option of the stockholders four years after the date of its issue (30 September 20X7) on the basis of 20 shares for each GH¢100 of loan stock. Alternatively it will be redeemed at par.
Accra Advisors had advised that if Bolgania Ltd had issued similar loan stock without the conversion rights, then it would have had to pay an interest (coupon) rate of 10% on the loan stock. This is because the terms of conversion to equity shares are favourable.
Accra Advisors further advised that because it is almost certain that the loan stock holders will exercise their right to convert to equity shares, the loan stock has the substance of equity and can be included as such on the statement of financial position. This has the added advantage of improving/reducing the company’s gearing (debt/equity) in comparison to what would be the case with the issue of ‘straight’ loan stock.
The present value of GH¢1 receivable at the end of each year, based on discount rates of 6% and 10% can be taken as:
Required
In relation to the 6% convertible loan stock, calculate the finance cost to be shown in the statement of profit or loss and the extracts from the statement of financial position for the year to 30 September 20X4; and comment on Accra Advisors’ advice.
Answer
IAS 32 Financial Instruments: Disclosure and Presentation says that the issuer of a compound (hybrid) instrument (i.e. one that contains both a liability debt and an equity element) should classify the instrument’s components separately. Thus the advice of Accra Advisors is wrong; convertible loan stock cannot be classified as pure equity. The proceeds of the issue have to be split between the amount attributable to the conversion rights, which is then classed as equity, and the balance of the proceeds being classed a liability/debt. There are several methods of obtaining these amounts, but from the information given in the question these can only be calculated on a ‘residual value of equity’ basis:
| Cash flows | Factor at 10% | Present value | |
|---|---|---|---|
| GH¢’000 | GH¢’000 | ||
| Year 1 interest | 600 | 0.91 | 546 |
| Year 2 interest | 600 | 0.83 | 498 |
| Year 3 interest | 600 | 0.75 | 450 |
| Year 4 interest and capital | 10,600 | 0.68 | 7,208 |
| Total value of debt component | 8,702 | ||
| Proceeds of the issue | 10,000 | ||
| Equity component (residual amount) | 1,298 |
Statement of profit or loss:
Interest paid (6% of GH¢10 million) 600,000
Provision for additional finance costs 270,000
((10% × 8.702m) – 0.6m)
870,000
Statement of financial position:
Non-current liabilities:
6% Convertible Loan Stock (from above) 8,702,000
Provision for additional finance costs 270,000
8,972,000
Capital and reserves:
Option to convert to equity (from above) 1,298,000
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