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First of all, the answer given by Chris in the video is totally reasonable (If I’m Lisa I would choose $2 A share and perhaps sell them immediately to get $2 instead of $1 of redemption value).
Edited: Rewatching the video, I realised that Lisa is actually the company itself and not an investor. So it is basically identical with the question in notes. My apology.The question in notes (page 61) though, is modified and said the choice of the conversion of B shares lies within the company. I checked the answer and it is definitely reasonable; it is better to convert it at company standpoint since we don’t have to pay any cash and $2 per share isn’t that too expensive for us to bear (basically we just have to pay more dividend in future as opposed to $1m cash now), this is especially appropriate if our company facing some problem in cash flow.
However, if I’m the company, I would rather redeem B shares at $1 with the reference to following case:
1) I will raise a share issue of 1 million unit of A shares at $2 per share (or right issue, or maybe at a price that is slightly lower than the MV at that date. For simplicity, we use $2).
2) It gives us a $2 million of cash proceed.
3) I will then redeem the B shares with $1million.
4) I got the extra $1million in my pocket.
5) the nett impact is: settle the B shares, our company has 1 million unit more of A shares(share capital and share premium in SFP) and $1million of cash.If we convert B shares directly, the nett impact would be:
We settle the B shares, our company has 1 million unit more of A Shares(share capital in SFP).It is therefore, more beneficial for the company to redeem the B shares at nominal value; thus, we recognise it as a financial liability.
I understand that this is perhaps a bit of extrapolating of the scenario. Still, I suppose it is a logical comparison between the alternatives a company could take in order to maximise their utility.
I also understand that there are many solutions to a single problem. So, would I still gain marks if I meet this question and I answering it by putting forward the case?Thank you for your time on reading my question. And always, thanks for the efforts on nurturing the students.
The short answer is that the examiner is looking for evidence that you can:
1. Define financial liability and equity for 50% of marks.
2. Apply the definition in a short scenario for 25% of marks.
3. Quantify any adjustment in line with your application for 25% of marks. So, even if your application is wrong, you will probably still get the method marks for the numbers.Furthermore, there is no harm in saying ‘this may be a liability because……’ as opposed ‘this definitely is a …………’
At this level they are looking for us to appreciate that SBR is an art not a science.
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