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A company issues $20M of 4% convertible loan notes at par on 1 january 2009. The loan notes are redeemable for cash or convertible into equity shares on the basis of 20 shares per $100 of debt at the option of the loan note holder on 31 december 2011. Similar but non-convertible loan notes carry an interest rate of 9%.
The present value of $1 receivable at the end of the year based on discount rates of 4% and 9% can be taken as
4% 9%
End of year 1 0.96 0.92
2 0.93 0.84
3 0.89 0.77
Cumulative ——- ——-
Cumulative 2.78 2.53
Show how these loan notes should be accounted for in the financial statements at 31 december 2009.Statement of profit n loss
Finance costs(w2) 1568
Sofp
Equity option to convert(w1) 2576
Non current liability
4% convertible loan notes(W2) 18192Working
1
Equity and liability elements $000
3 yrs interest(20000×4%×2.53) 2024
redemption(20000×0.77) 15400
Liability element 17424
Equity element 2576
Proceeds of loan notes 200002 loan note balance
Liability element(W1) 17424
Interest for the year at 9% 1568
Less interest paid (20000×4%) (800)
Carrying value at 31/12/09 18192My question is
they have calculated finance cost on the basis of 9% interest why not 4% interest?“they have calculated finance cost on the basis of 9% interest why not 4% interest?” – because 9% is the effective rate
The coupon rate is 4%, sure, but it’s only so low because of the equity conversion option
The ‘real’ rate of interest is 9% and that’s the basis of the calculation for the finance cost in the statement of profit or loss
Hello sir!
What is the “real” rate is lower then the interest rate promised to the loan holders? What rate should we use when calculating fin cost?
Thank you!
Hi,
I doubt that in reality you would have this situation as it would not be beneficial to the investor and you wouldn’t get the funds expected. Whatever the rate is, be it lower or higher, we will always use the effective rate to record the interest expense/finance cost through profit or loss.
Thanks
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