QUESTION 42 Illustration 32: Optionally convertible debentures with issuer’s redemption option 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 coupon of RBI base rate plus 1% p.a. The prevailing market rate for similar preference shares, without the conversion feature or issuer’s redemption option, is RBI base rate plus 4% p.a. On the date of contract, RBI base rate is 9% p.a. Calculate the value of the liability and equity components.
Solution
The fair value of the preference shares needs to be determined before the liability and equity components can be calculated. The fair value is calculated as the present value of the expected cash flows, discounted at the appropriate market rate of interest.
The expected cash flows from the preference shares are the coupon payments and the redemption value at the end of 3 years if the option to convert is not exercised.
Using the prevailing market rate of interest for similar preference shares without the conversion feature or issuer’s redemption option (RBI base rate plus 4% p.a.), the fair value of the preference shares can be calculated as follows:
Fair value of preference shares = ($60,000 x PVIFA(13%,3)) + ($10,00,000 / (1+0.13)^3)
= ($60,000 x 2.283) + ($10,00,000 / 1.464)
= $1,36,980 + $6,82,504
= $8,19,484
Once the fair value of the preference shares is determined, we can 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 an issuer’s redemption option at the end of 3 years, 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 redemption value of $10 lakhs, discounted at the appropriate market rate of interest. In this case, the appropriate market rate of interest is RBI base rate plus 4% p.a. because it reflects the credit risk of the issuer.
Liability component = ($10,00,000 / (1+0.13)^3) = $6,82,504
Equity component = fair value of preference shares, say, $ 8,19,484 less financial liability component, i.e. $6,82,504 = $1,36,980
Therefore, the value of the liability component is $6,82,504, and the value of the equity component is $1,36,980.
Note: PVIFA denotes the present value interest factor of an annuity, calculated using the appropriate market rate of interest.