Question

High PG Ltd is a production company with an average return on assets of 8.0% and an average cost of debt of 7.7%. The company needs to raise additional funds in a competitive market environment. The Balance Sheet shows the company is currently financed as follows:

Equity and Liabilities

Position AUD

Current Liabilities $ 33,033,000

Non-Current Liabilities $ 9,317,000

Total Liabilities $ 42,350,000

Share Capital $ 85,425,000

Accumulated losses $ (28,475,000)

Total equity $ 56,950,000

As the personal assistant of the CFO L. Winters, you have been asked to evaluate the following opportunities to acquire $15 million of new capital and to provide advice at the board of directors meeting on September 10th, 2018.

High PG Ltd Step-up Bond

Instrument: Step-up Bond

Issue size: AUD 15million

Coupon: 8%,10%,12% annual payment

Issue Price: 100.00% (par)

Settlement date: 01-January-2019

Maturity date: 31-December-2021

OR

High PG Ltd Convertible Bond

Instrument: Convertible Bond

Issue size: AUD 15million

Coupon: 5%, annual payment

Settlement date: 01-January-2019

Maturity date: 31-December-2021

Conversion rate: 15million $1 shares at maturity

Note: Without the conversion feature, the bond would be priced the same as the corporate Bond.

(1) Provide a short introduction.

(2) Provide and explain the journal entries for the High PG Ltd Step-up Bond from 1 January 2019 to 31 December 2021. Refer to the specific Australian accounting standards.

(3) Provide and explain the journal entries for the High PG Ltd Convertible Bond from 1 January 2019 to 31 December 2021. Refer to the specific Australian accounting standards. Assume the bond is converted at maturity.

(4) Assuming a net profit (after interest and tax) of 10 MAUD, provide a forecast of the equity and liability sections of the Balance sheet as at 31 December 2019 for each bond. Based on the effects of these different options on the financial statements of High PG Ltd, provide a recommendation to the CFO and board of directors.

Answer 1

(1) Short Introduction:

The objective of a company is to increase the shareholders' wealth. In the given case, the company needs to raise the funds amounting $15 mns for a period of 3 years from the competitive market. It has 2 options for raising the fund:

(i) Step up Bond

(ii) 5% Convertible Bond

We need to evauate the two options to raise funds for new capital.

(2) Journal entries for Step up Bond:

Date	Particulars	Dr.($)	Cr.($)
1-Jan-2019	Bank A/c..................Dr	15,000,000
	To Bondholders A/c		15,000,000
	(Being money on application received)
1-Jan-2019	Bondholders A/c......Dr.	15,000,000
	To Step up Bond A/c		15,000,000
	(Being the amount transferred)
31-Dec-2019	Profit and Loss A/c......Dr.	1,200,000
	To Finance Cost		1,200,000
	(15,000,000*8%)
31-Dec-2019	Finance Cost A/c......Dr.	1,200,000
	To Bank A/c		1,200,000
	(Being payment made to bond holders)
31-Dec-2020	Profit and Loss A/c.....Dr.	1,500,000
	To Finance Cost		1,500,000
	(15,000,000*10%)
31-Dec-2020	Finance Cost A/c.....Dr.	1,500,000
	To Bank A/c		1,500,000
	(Being payment made to bond holders)
31-Dec-2021	Profit and Loss A/c.....Dr.	1,800,000
	To Finance Cost A/c		1,800,000
	(15,000,000*12%)
31-Dec-2021	Finance Cost A/c.....Dr.	1,800,000
	To Bank A/c		1,800,000
	(Being payment made to bond holders)
31-Dec-2021	Step up Bond A/c....Dr.	15,000,000
	To Bondholders' A/c		15,000,000
	(Being liability of payment arise on maturity)
31-Dec-2021	Bondholders' A/c....Dr.	15,000,000
	Bank A/c		15,000,000
	(Being liability paid off)

(3) The second option is to issue 5% Convertible bonds on 1-Jan-2019, maturity after 3 years i.e. on 31-Dec-2021. The interest cost with no conversion rights (i.e. cost of debt) is 7.70% p.a. Hence, we need to separate the debt and equity component at the time of issue of bons.

Computation of Debt and Equity component of Convertible Debentures as on 1-Jan-2019

Particulars	$
Present Value of the principle repayable after 3 years [15,000,000*0.8005] (3rd year discounting factor @ 7.70%)	12,007,500
Add: Present Value of Interest [15,000,000*5%*2.5911] (3 years cummulative discounting factor @ 7.70% p.a.	1,943,325
Total Present value of debt component	13,950,825
Issue proceeds from convertible debentures	15,000,000
Value of Equity Component	1,049,175

Table showing bond liability at the end of each year:

Particulars	Year 1	Year 2	Year 3
Beginning	13,950,825	14,275,038	14,624,216
Add: Interest @ 7.70%	1,074,213	1,099,178	11,25,784
	15,025,038	15,374,326	15,750,000
Less: Interest @ 5%	(750,000)	(750,000)	(750,000)
Carrying Amount	14,275,038	14,624,216	15,000,000

Journal entries for Convertible Bond:

Date	Particulars	Dr.($)	Cr.($)
1-Jan-2019	Bank A/c..................Dr	15,000,000
	To Bondholders A/c		15,000,000
	(Being money on application received)
1-Jan-2019	Bondholders A/c......Dr.	15,000,000
	To 5% Convertible Bond (Debt component)A/c		13,950,825
	To 5% Convertible Bond (Equity component)A/c		1,049,175
	(Being the amount transferred)
31-Dec-2019	Profit and Loss A/c......Dr.	1,074,213
	To Finance Cost		1,074,213
	(13,950,825*7.70%)
31-Dec-2019	Finance Cost A/c......Dr.	1,074,213
	To 5% Convertible Bond (Debt component)A/c		324,213
	To Bank A/c		750,000
	(Being payment made to bond holders)
31-Dec-2020	Profit and Loss A/c.....Dr.	1,099,178
	To Finance Cost		1,099,178
	(14,275,038*7.70%)
31-Dec-2020	Finance Cost A/c.....Dr.	1,099,178
	To 5% Convertible Bond (Debt component)A/c		349,178
	To Bank A/c		750,000
	(Being payment made to bond holders)
31-Dec-2021	Profit and Loss A/c.....Dr.	11,25,784
	To Finance Cost A/c		11,25,784
	(14,624,216*7.70%)
31-Dec-2021	Finance Cost A/c.....Dr.	11,25,784
	To 5% Convertible Bond (Debt component)A/c		375,784
	To Bank A/c		750,000
	(Being payment made to bond holders)
31-Dec-2021	5% Convertible Bond (Debt component)A/c Dr.	15,000,000
	To Equity Share Capital		15,000,000
	(Being bond converted into shares at the end of 3 years)

(4) Evaluation of both the options:

Particulars	Option 1 Step up Bond	Option 2 Convertible Bond
Net Profit after tax and interest	10,000,000	10,000,000
Less: Finance Cost	1,200,000	1,074,213
Net Profit after new finance cost	8,800,000	8,925,787

By looking into the above analysis, it can be seen that Option 2 yield better Net profit than the option 1. Hence, it is recommended to proceed with Option 2 i.e. raising funds using Convertible Bond. However, convertible bonds wll be more riskier form of capital than the normal bond.