Accounting Business Reporting for Decision Making

CHAPTER 13 Financing the business 551

VALUE TO BUSINESS

•   Owners of companies may at times wish to expand their companies or liquidate some or all of their

ownership rights by selling ownership rights or shares to other investors.

•   Ownership rights are traded and transferred by means of ordinary shares and preference shares.

•   All companies issue ordinary shares; some, but not all, companies issue preference shares.

•   Another method which companies use to raise further capital is by means of rights and options, which

confer the right to subscribe to shares in the future at a price and time which are predetermined.

13.8 Hybrid finance

LEARNING OBJECTIVE 13.8 Discuss hybrid financial instruments.

Hybrid debt securities are securities that have characteristics of both debt and equity. The principal

hybrid securities are convertible notes and convertible preference shares. Convertible notes convert to

the issuer’s ordinary shares, while convertible preference shares also convert at maturity to the issuer’s

ordinary shares. The principal difference between the two is that convertible notes pay interest, and con-

vertible preference shares pay dividends, which are usually fully franked. With both types of securities,

however, the issuer receives cash only on issue. Eventual conversion to ordinary shares is a cashless

transaction. The classification of hybrid instruments in the balance sheet is problematic.

Convertible notes

Convertible notes, while all converting ultimately to the issuer’s ordinary shares, nevertheless are

issued with varying conditions. However, as entities issuing convertible notes are generally interested in

claiming tax deductions for the interest payable on them, the notes are normally issued with conditions

that are acceptable to the ATO under the legislation. Chief among these conditions are that:

• the interest rate is fixed


• note-holders, not issuers, decide when to convert notes to ordinary shares


• conversion must take place between two and ten years from date of issue, so long as the note maturity

is not less than two years.

The notes are normally unsecured and often subordinated, but some notes may not be issued with

these conditions. Subordinated notes are issued when an entity has several issues of similar notes and

wishes to indicate precedence in redemption should the entity fail.

Convertible preference shares

Convertible preference shares (CPS) are preference shares that the owner can exchange for a certain

number of ordinary shares. CPS generally do not convert to ordinary shares in a fixed ratio, such as one for

one, or one for two, as was the case with convertible notes. Normally, the conversion ratio is calculated by

taking into account the volume-weighted average sale price on the ordinary shares on the market in the past

5 to 20 days before the conversion date. Additionally, a discount rate of 2.5–10 per cent is applied to the

average market price to enhance the conversion ratio to increase the benefits to the investor.

VALUE TO BUSINESS

•   Hybrid debt instruments are instruments that have characteristics of both debt and equity.

•   The principal hybrid instruments are convertible notes and convertible preference shares.

•   Both convertible notes and convertible preference shares convert at maturity to the issuer’s ordinary shares.

•   The principal difference between the two is that convertible notes pay interest, and convertible

preference shares pay dividends, which are usually fully franked.

•   The issuer receives cash only on issue, and the eventual conversion to ordinary shares is a cashless

transaction.