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Please, could anyone aid me to understand the answer about NOTE 7 long term borrowing/ convertible loan , this note is from exam DipIFR December 2017.
On 1 October 2016, Alpha issued 60 million $1 loan notes at par. The annual rate of interest (payable in arrears) on the loan notes is 6%. The loan notes are repayable at par on 30 September 2026. As an alternative to repayment, the holders of the loan notes can elect to convert their loan notes into equity shares of Alpha on 30 September 2026. Had the conversion option not been available, the investors in the loan notes would have required an annual return of 9%.
Discount factors which may be relevant at 6% and 9% are as follows:Discount Present value of Present value of
rate $1 receivable in $1 receivable at the
10 years end of years 1–10
6% 55·8 cents $7·36
9% 42·2 cents $6·42In preparing the draft financial statements for the year ended 30 September 2017, the directors of Alpha credited $60 million to long-term borrowings and showed the interest paid to the investors as a finance cost.
The answer is:
Present value of interest stream (60,000 x 6% x 6·42) 23,112
Present value of repayment amount (60,000 x 0·422) 25,320
So loan component is 48,432
Annual finance cost at 9% is 4,359
Finance cost charged in draft financial statements of Alpha
(60,000 x 6%) (3,600 )So adjustment equals 759
I don’t understand why the PV of interest stream is multiplying by 6,42 and the PV of repayable amount is multiplying by 0,422
Thanks a lot
The PV of $1 receivable/payable in n year’s time is calculated as 1/(1+r)n (that’s to the power of n), where r is the relevant discount rate. This is called a “simple” discount factor.
The PV of $1 receivable/payable for ever year from years 1 – n (i.e. an annuity) is the sum of the simple discount factors for years 1 – n:
1/(1+r) + 1/(1+r)2 + 1/(1+r)3 … 1/(1+r)n (again these are powers). This is called a “cumulative” discount factor.
You will not be expected to calculate these in the exam – they will always be given in the Q.In this particular Q the interest stream is 6% x $60m = $3.6m per annum receivable at the end of years 1-10 – so it is multiplied by the cumulative discount factor 6.42 (given); the simple discount factor 0.422 is applied to the cash flow on repayment at the end of year 10.
If your question is why does the answer use the 9% discount factors rather than the 6% discount factors, it is because this is the relevant cost of capital/return which takes into account the redemption (again this will always be given). The 6% rate on the loan itself is relevant only to the calculation of the cash flows – it would be incorrect to use this as a discount rate.
Hello,
I saw this question accidentally and I wonder why do you use 60,000 instead of 6 million? Is is just to avoid zeros or what?
Thank you
Thank you for your kind answer.
But I have another question.
If annual interest of principal $6,000,000 is $60,000, interest rate should be 1%.
However there is no 1% interest rate given in the question.
How you find this annual interest rate?
I got confused. thank you again
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