QUESTION 41 Illustration 31: Optionally con. Redeemable preference shares (continued from Illustration 29) On 1 July 2018, D Limited issues preference shares to G Limited for a consideration of $ 10 Lakhs. The holder has an option to convert these preference shares to a fixed number of equity instruments of the issuer anytime up to a period of 3 years. If the option is not exercised by the holder, the preference shares are redeemed at the end of 3 years. The preference shares carry a fixed coupon of 6% p.a. The prevailing market rate for similar preference shares, without the conversion feature, is 9% p.a. Calculate the value of the liability and equity components.
Solution
To calculate the value of the liability and equity components, we need to first determine the fair value of the preference shares.
The fair value of the preference shares can be calculated as the present value of the expected cash flows, discounted at the appropriate market rate of interest. In this case, the appropriate market rate of interest is 9% p.a. because it is the prevailing market rate for similar preference shares without the conversion feature.
The expected cash flows from the preference shares are the fixed coupon payments of $60,000 per year (6% of $10 lakhs) and the redemption value of $10 lakhs at the end of 3 years if the option to convert is not exercised. Therefore, the fair value of the preference shares can be calculated as follows:
Fair value of preference shares = ($60,000 x PVIFA(9%,3)) + ($10,00,000 / (1+0.09)^3)
= ($60,000 x 2.531) + ($10,00,000 / 1.295)
= $1,51,836 + $7,72,176
= $9,24,012
Next, we need to allocate the fair value between the liability and equity components based on the specific terms and conditions of the preference shares.
In this case, the preference shares have a fixed redemption date of 3 years from the date of issue, which creates an obligation for the issuer to pay cash to the holder at maturity. Therefore, a portion of the fair value can be allocated to the liability component. The equity component would be the remaining fair value of the preference shares after deducting the liability component.
The liability component can be calculated as the present value of the fixed redemption value of $10 lakhs, discounted at the appropriate market rate of interest. In this case, the appropriate market rate of interest is still 9% p.a. because it reflects the credit risk of the issuer.
Liability component = ($10,00,000 / (1+0.09)^3) = $7,72,176
Equity component = fair value of preference shares, say, $ 9,24,012 less financial liability component, i.e. $7,72,176 = $1,51,836
Therefore, the value of the liability component is $7,72,176, and the value of the equity component is $1,51,836.
