Convertible bonds and share-based payment at Meridian Ltd
On 1 January 2024, Meridian Ltd issued $20 million of 4% convertible bonds at par. Interest is paid annually in arrears and the bonds mature on 31 December 2027. Each $1,000 bond is convertible into 200 ordinary shares at the holder's option. The market rate for similar non-convertible debt is 7%. Issue transaction costs were $600,000. The present value factors at 7% for four years are 0.7629 for $1 and 3.3872 for an annuity. After allocating transaction costs, the effective interest rate on the liability component is 8.87%. On 1 January 2024, Meridian also granted 500,000 share options to employees. The options vest on 31 December 2026 if the employee remains employed and cumulative revenue growth exceeds 6% over the three-year period. At grant date the fair value was $3 per option. At 31 December 2024, management expects 90% of employees to remain and revenue growth to exceed 6%. No options had vested or been exercised by year end.
1. Calculate the initial carrying amounts of the liability and equity components of the convertible bonds after allocating transaction costs. Show the allocation.
Read the worked answer
First measure the liability component at the present value of contractual cash flows using the 7% market rate for non-convertible debt:
- Present value of principal: $20m x 0.7629 = $15.258m.
- Present value of interest: $20m x 4% = $800,000; $800,000 x 3.3872 = $2.70976m.
- Liability component before transaction costs: $15.258m + $2.70976m = $17.96776m, say $17.968m.
- Equity component before transaction costs: $20m - $17.968m = $2.032m.
Transaction costs of $600,000 are allocated pro rata to the liability and equity components based on their initial carrying amounts:
- Liability share: $600,000 x 17.968/20 = $539,040.
- Equity share: $600,000 x 2.032/20 = $60,960.
Initial carrying amounts after transaction costs:
- Liability: $17,967,760 - $539,040 = $17,428,720, say $17.429m.
- Equity: $2,032,240 - $60,960 = $1,971,280, say $1.971m.
The total is $19.4m, equal to proceeds of $20m less transaction costs of $600,000.
2. Calculate the finance cost and closing liability for 2024 using the effective interest rate of 8.87%.
Read the worked answer
The liability is measured at amortised cost using the effective interest method. The 2024 finance cost is calculated on the opening liability, not on the coupon:
- Opening liability: approximately $17,428,720.
- Finance cost: $17,428,720 x 8.87% = $1,545,927, say $1,545,900.
- Coupon paid: $20m x 4% = $800,000.
- Liability increase: $1,545,900 - $800,000 = $745,900.
- Closing liability: $17,428,720 + $745,900 = $18,174,620, say $18.175m.
The $800,000 coupon is a cash payment, not the full expense. The difference of approximately $745,900 increases the liability and is included in finance cost. The equity component remains at approximately $1.971m and is not remeasured.
3. Calculate the 2024 share-based payment expense and explain how the revenue growth condition affects measurement.
Read the worked answer
The grant is equity-settled. The fair value at grant date is $3 per option. The revenue growth condition is a non-market performance condition, so it is reflected in the estimate of the number of awards expected to vest rather than in the fair value of the options.
At 31 December 2024, management expects 90% of employees to remain and the revenue target to be met. The expected number of vesting options is 500,000 x 90% = 450,000. The three-year vesting period means one year of the service condition has been completed.
2024 expense = 450,000 options x $3 x 1/3 = $450,000.
If the revenue growth target were not expected to be met, the expense would be nil, even though the employees had provided service. Estimates are revised each year, with any cumulative adjustment taken to profit or loss.