Question

Question 4: (10 Marks)

1.     DES started the business and issued 10,000 ordinary shares (par value $2) at $20 per shares in 2000. The fiscal year is from January 1 to December 31 each year.

On October 1, 2011, DES issued a two-year callable financial instrument for $500,000. The rates of return for the first year and the second year are 2% and 3% respectively, payable annually at the end of each year. The rate of return for an instrument with similar credit risk but without a redemption option is 2.5%. DES has the right to redeem the certificate of deposit at face value at any time before maturity. If the redemption does not occur, the holder will receive the amount of initial investment back at maturity.

Required:  

Determine whether the financial instrument should be classified as a financial liability, an equity instrument or a compound instrument.      (5 marks)

2.   On April 1, 2011, Sister Ltd. issued a financial instrument to Mr. Chan for $1,000,000. The rate of return is linked to the movement in gold price over the next twelve months. If, at any time in the next twelve months, the gold price is higher than HK$10,000 per ounce, Mr. Chan will receive 3% return on investment. Otherwise, the return on investment will be 0%. Mr. Chan’s investment and return on investment will be delivered to him on March 31, 2012.               

Required:

Determine the classification of Sister’s financial instruments above. Justify your answer.                                                                                                                                    (5 marks)

Answer 1

Year Return Present value factor @ 2.5% Present values $ 10,000.00 $ 15,000.00 0.975609756 $ 0.951814396 $ 9,756.10 14,277.22 1 500000*2% 2 500000*3% Intial investment repyament $500,000.00 0.951814396 $ 475,907.20 Financial liability Equity Component $ $ 499,940.51 59.49 As the financial instruemts are callable, it contains equity component as well as liability component, so it would be a Compund instrument