Valuation of Compulsorily Convertible Bonds
Vikash Goel
Founder @ Omnifin | Valuation Expert, Consultant, CA Business Leader 40under40, CA, IIM-Cal
Ind AS 109 and Ind AS 32 (Equivalent of IFRS 9 and IAS 32) provides specific guidance on valuation of compound instruments. Compound instruments are those financial instruments that that contain both a liability and an equity element. These elements are classified into separate component parts. The liability is initially measuring by discounting the future cash flows to their present values. The discount rate to be used is the effective interest rate of the instrument (i.e. a market rate). This effective interest rate will be higher than the coupon rate of the instrument. This is because the bond holders are prepared to accept lower cash interest for the benefit of the option to convert the debt in the future. The equity component is the residual amount after deduction of the more easily measurable debt component from the value of the instrument as a whole.
When an entity issues convertible bonds with an option to the holder to convert them into equity instruments in the future. Such bonds consist of:
???????? the obligation to repay the bonds, which should be presented as a liability; and
???????? the option to convert, which should be presented in equity.
Example: Valuation of Compulsorily Convertible Debentures
An entity issues 20,000 convertible INR 1,000 bonds at par on 1 January 20x0. Interest is payable annually in arrears at a nominal interest rate of 6.5%. The prevailing market rate of interest at the date of issue of the bond was 9%. The bond is redeemable 31 December 20x5.
Solution:
While the contractual interest payable is 6.5%. So the cash flows is INR 13,00,000 every year. This amount should be discounted at the effective rate of interest i.e., 9%. The Sum of this is the Present Value of Interest Payments. Also, the Present Value of the Principal payment i.e., 2,00,00,000 should also be calculated using a discount rate of 9%.
The sum of these amounts together is the liability component of the CCD. The balance amount of proceeds is the equity portion
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.The equity and the liability portion of the hybrid security is separated.
The Liability and Equity will stand as follows during the life of the CCD.
The convertible bond is a compound instrument and should be valued separately based on its liability and equity component. While the amount of liability is lower at initial measurement, it will accumulate towards redemption value at maturity.