QUESTION 31 Illustration 21: Con. ratio changes if issuer subsequently issues shares to others at a lower price On 1 January 2018, PG Limited subscribes to convertible preference shares of BG Limited at $ 100 per preference share. The preference shares are convertible in the ratio of 10:1 i.e. 10 equity shares for each preference share held. On a fully diluted basis, PG Limited is entitled to 30% stake in BG Limited. If subsequent to the issuance of these convertible preference shares, BG Limited issues any equity instruments at a price lower than $ 10 per share, conversion ratio will be changed to compensate PG Limited for dilution in its stake below the expected dilution at a price of $ 10 per share. Examine the nature of the financial instrument.

Solution

The nature of the financial instrument held by PG Limited in BG Limited is a convertible preference share. This is because the instrument can be converted into equity shares of BG Limited at a predetermined ratio of 10:1. In other words, each preference share held by PG Limited can be converted into 10 equity shares of BG Limited.

However, the terms of the instrument also provide for a change in the conversion ratio if BG Limited issues any equity instruments at a price lower than $10 per share. The purpose of this provision is to compensate PG Limited for any dilution in its stake in BG Limited below the expected dilution at a price of $10 per share. This means that if BG Limited issues equity instruments at a price lower than $10 per share, the conversion ratio for PG Limited's preference shares will be adjusted to reflect the lower price and compensate PG Limited for the dilution.

It is important to note that the provision for adjustment in the conversion ratio based on subsequent issuance of equity instruments at a lower price is a typical feature of convertible securities. This feature is designed to protect the interest of the convertible security holder and ensure that their stake in the company is not unduly diluted.

In summary, the financial instrument held by PG Limited in BG Limited is a convertible preference share with a provision for adjustment in the conversion ratio based on subsequent issuance of equity instruments at a lower price.

However, in this case, the variability in the conversion ratio, which is designed to compensate PG Limited for dilution in its stake, may create a financial liability. This is because the issuer, BG Limited, may be required to issue additional equity shares to PG Limited at a lower price than the market price, which would result in a financial liability for BG Limited.

Therefore, the convertible preference shares held by PG Limited in BG Limited will likely be classified as a financial instrument, and the specific classification will depend on the terms and conditions of the instrument, including the variability in the conversion ratio.


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