DipIFR Syllabus B. Elements of financial statements - Financial Liabilities - convertible loans - Notes ^{4 / 12}

Anything with an obligation is a liability (debt).

However we now have a problem when we consider convertible payable loans. The ‘convertible’ bit means that the company may not have to pay the bank back with cash, but perhaps shares.

So is this an obligation to pay cash (debt) or an equity instrument?

In fact it is both! It is therefore called a Compound Instrument

Convertible Payable Loans

These contain both a liability and an equity component so each has to be shown separately.

• This is best shown by example:

  2% Convertible Payable Loan €1,000

• This basically means the company has offered the bank the option to convert the loan at the end into shares instead of simply taking €1,000

• The important thing to notice is that that the bank has the option to do this.

• Should the share price not prove favourable then it will simply take the €1,000 as normal.

Features of a convertible payable loan

1. Better Interest rate 

   The bank likes to have the option. Therefore, in return, it will offer the company a favourable interest rate compared to normal loans

2. Higher Fair Value of loan

   This lower interest rate has effectively increased the fair value of the loan to the company (we all like to pay less interest ;-)) 

   We need to show all payable loans at their fair value at the beginning.

3. Lower loan figure in SFP 

   Important: If the fair value of a liability has increased the amount payable (liability) shown in the accounts will be lower. 

   After all, fair value increases are good news and we all prefer lower liabilities!

How to Calculate the Fair Value of a Loan

So how is this new fair value, that we need at the start of the loan, calculated?

Well it is basically the present value of its future cashflows…

• Step 1: Take what is actually paid (The actual cashflows):

  Capital €1,000
  Interest (2%)  €20 pa.

  Now let’s suppose this is a 4 year loan and that normal (non-convertible) loans carry an interest rate of 5%.

• Step 2: Discount the payments in step 1 at the market rate for normal loans (Get the cashflows PV)

  Take what the company pays and discount them using the figures above as follows:

  Capital €1,000 discounted @ 5% (4 years SINGLE discount figure) = 1,000 x 0.823 = 823

  Interest €20   discounted @ 5% (4 years CUMULATIVE)= 20 x 3.546= 71

  Total = 894
   
  This €894 represents the fair value of the loan and this is the figure we use in the balance sheet initially.

  The remaining €106 (1,000-894) goes to equity.

  Dr Cash 1,000
  Cr Loan 894
  Cr Equity 106

• Next we need to perform amortised cost on the loan (the equity is left untouched throughout the rest of the loan period). 

  The interest figure in the amortised cost table will be the normal non-convertible rate and the paid will be the amounts actually paid. 

  The closing figure is the SFP figure each year

Now at the end of the loan, the bank decide whether they should take the shares or receive 1,000 cash…

1. Option 1: Take Shares (lets say 400 ($1) shares with a MV of $3)

   Dr Loan 1,000
   Dr Equity 106
   Cr Share Capital 400
   Cr Share premium 706 (balancing figure)

2. Option 2: Take the Cash

   Dr Loan 1,000
   Cr Cash 1,000

   Dr Equity 106
   Cr Income Statement 106

Conclusion

1. When you see a convertible loan all you need to do is take the capital and interest PAYABLE.

2. Then discount these figures down at the rate used for other non convertible loans.

3. The resulting figure is the fair value of the convertible loan and the remainder sits in equity.

4. You then perform amortised cost on the opening figure of the loan. Nothing happens to the figure in equity

Convertible Payable Loan with transaction costs - eek!

Ok well remember our 2 step process for dealing with a normal convertible loan? No?? Well you’re an idiot. However, luckily for you, I’m not so I will remind you :p

Step 1) Write down the capital and interest to be PAID

Step 2) Discount these down at the interest rate for a normal non-convertible loan

Then the total will be the FV of the loan and the remainder just goes to equity. Remember we do this at the start of the loan ONLY.

Right then let’s now deal with transaction or issue costs.

These are paid at the start.

Normally you simply just reduce the Loan amount with the full transaction costs.

However, here we will have a loan and equity - so we split the transaction costs pro-rata

I know, I know - you want an example…. boy, you’re slow - lucky you’re gorgeous

eg 4% 1,000 3 yr Convertible Loan. 
Transaction costs of £100 also to be paid. 
Non convertible loan rate 10%

Step 1 and 2

Capital 1,000 x 0.751 = 751
Interest 40 x 2.486 = 99 (ish)
Total = 850

So FV of loan = 850, Equity = 150 (1,000-850)

Now the transaction costs (100) need to be deducted from these amounts pro-rata

So Loan = (850-85) = 765
Equity (150-15) = 135

And relax….