Question

Thunderbolt plc raised finance through the issue of shares on 1 April 2018. The company issued convertible bonds at their nominal value of K20 million. Interest is payable annually in arrears at the rate of 5%. The conversion would be done on the following terms: Each K4000 bond is convertible at any time up to maturity into 800 ordinary shares. Alternatively, the bonds would be redeemed at par after 4 years in 2022. The market rate applicable to non-convertible bonds is 9%. (The present value of $1 payable at the end of the year, based on rates of 5% and 9% are given in the table of the Appendix at the end of the question paper.) Required:

a) Explain why recognition of convertible bonds should be split into the liability component and the equity component, and calculate the two amounts Thunderbolt recognised.
b) Prepare an amortisation schedule showing amounts outstanding at the end of each of the four years to 31 March 2022 (Work to the nearest $000)
c) State what amounts would be reported in the statement of profit or loss and other comprehensive income for the year to 31 March 2020 in respect of the bonds, and

Answer 1

Answer:

a) In case of the issue of convertible bonds, the company must split the proceeds between equity and liability. This is because, if the investors were investing solely for the purpose of earning interest income, they would have wanted a 9% rate of return on their investment. But since the convertible debt allows them an OPTION to convert their debt to shares, they are ready to settle for only 5% of interest rate.

Now in effect, the company has underwritten and option for sale of the shares and the savings in interest are reflective of the option premium the company has received. The company, had it issued only debt without a conversion option, would have received only the present value of future flows discounted at the rate of 9% which is the market rate. This amount comes out to be $17,408.32 as shown below. the rest of the consideration received is for the option premium which the company has given.

In case of giving the option, the option may be exercised or not, in either case, the option premium has been received and the same must be booked as equity and should not be shown as a liability. On this reasoning, the proceeds of debt issue are split between equity and liability.

b) Ammortisation schedule for the liability portion is given as under.

c) As can be seen from the schedule given in b) above, an expense amounting to $1,617.76 will be shown as Finance Cost in the statement of profit or loss and other comprehensive income for the year to 31 March 2020 in respect of the bonds.

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