(29-06-2013, 12:47 AM)greengreengrass Wrote: boon, are you saying the effective interest rate of 32% as calculated by d.o.g. was wrong?
(24-06-2013, 03:35 PM)Boon Wrote: Corporate Tax Rate in PRC is 25%. Since interest expenses are tax deductible, therefore, it should be fully accounted for as well.
Also, the subscription price of RMB 100.5 million is for BOTH Bonds and Warrants.
Subscription Price of Bond (SPB) + Subscription Price of Warrants (SPW) = RMB 100.5 million
SPB + SPW = 100.5
Principal Amount of Bond (PAB) = RMB 134 million
Discount to PAB (DPAB) = PAB – SPB = PAB – 100.5 + SPW = 134 – 100.5 + SPW = 33.5 + SPW
Assuming DPAB could be amortized over two years with tax deductibility
SPW up < = > SPB down < = > DPAB up < = > tax deductible (TD) up < = > effective annual interest rate (EAIR) down
SPW (zero) < = > SPB (100.5) < = > DPAB (33.5) < = > EAIR (24%)
SPW (33.5) < = > SPB (67) < = > DPAB (67) < = > EAIR (20%)
See Excel File attached
It is hard to ascribe a “correct” Effective Annual Interest Rate” without knowing the full details of the deal plus the relevant allowable accounting and tax treatment in PRC. For those that know how to do it (I am not one), I believe there are many ways to structure this deal.
No doubt, this hybrid security could be “decomposed” into its basic building blocks or components - Bond and an Equity Option – and with each component being analyzed independently - the key thing in the first place is to get the building blocks right.
Comments are most welcomed.
I do find this an interesting case study and am too following the developments with great enthusiasm.
I would not use the word “wrong” to describe the 32% effective annual interest rate worked out by d.o.g.
If you change all of the “tax deductibles” inputs in my attached excel file to zero (the one with subscription price of bond = RMB 100.5 million, subscription price for warrants = zero), you would get the same answer of 32% as calculated by d.o.g.
What I am saying is :
In d.o.g.’s calculation, tax deductibility of interest expenses have not been taken into consideration. IMO, it is the NET cash outflow that Eratat has to bear for the issuance of BOTH the bond and warrants that counts – not the GROSS amount.
Let’s work through the tax deductibles in detail:
1) Tax deductibles on Bond Coupon interest expense:
Principal amount of Bond = RMB 134 million
Coupon interest payments = 12.5% payable quarterly base on RMB 134 million = (1 + 0.125/4)^4 – 1 = 13.1% payable annually. = RMB 17.55 million per annum
Corporate tax in China is 25%, and Eratat has been profitable and paying quite substantial amount of tax every year since listing – enough tax to offset.
Tax deductible on coupon interest payments = 25% of 17.55 million = RMB 4.39 million.
In another words, net coupon interest payment incurred by Eratat is 75% of the actual payments and not 100%.
2a) Tax deductibles on Bond Discount ( SPB = RMB 100.5 million ; SPW = zero )
The subscription price of bond (SPB) + subscription price of warrants (SPW) = RMB 100.5 million
That is, we only know : SPB + SPW = 100.5 , but we do not know the proportional mix.
If we ASSUME: SPB =RMB 100.5 million and SPW = zero.
Discounted Price of bond = RMB (134 – 100.5) million = RMB 33.5 million
Assuming further that this amount of discount could be amortized over two years and is tax deductible,
“Discount amortization” per year = RMB 16.75 million per year.
Tax deductible on “discount amortization” = 25% of 16.75 = RMB 4.19 million per year
In another words, by selling the bond at 75% of PAR, Eratat is assumed to be entitled to tax deductibility on “discount amortization” of RMB 4.19 million per year for two years.
If the above 1 and 2a tax deductibles are taken into consideration, the “effective annual interest rate” would be reduced from 32% (as worked out by d.o.g.) to 24% instead (roughly a reduction of 25%) – Please refer to my excel file earlier.
2b) Tax deductibles on Bond Discount ( SPB = RMB 67 million ; SPW = RMB 33.5 million)
Now in the above calculation, we had assumed
SPB = RMB 100.5 million
SPW = zero
What if SPW is not zero, as d.o.g. had mentioned earlier, the warrants is out of money, but time is on its side and therefore it has some value.
Let’s assume if SPW = RMB 33.5 million (I am not implying this is the correct pricing to the warrants, it does seems high, but for the sake of the exercise, let’s assume this figure)
Assuming further that this amount of warrants subscription proceed of RMB 33.5 million would be treated as paid-in-capital and not an income, and therefore not taxable.
If SPW = RMB 33.5 million, then SPB = 100.5 – 33.5 = RMB 67 million
Bond discount became = 134 – 67 = RMB 67 million
“Discount Amortization” = 0.5 x 67 = RMB 33.5 million per year over two years.
Tax deductible on “discount amortization” = 25% of RMB 33.5 million = RMB 8.38 million per year over two years.
In this scenario, by ascribing a positive value to the warrants, the bond appears to be sold even at a bigger or deeper discount to PAR ( a lot more cheaper), and the “effective annual interest rate” for the bond issue alone would be even higher. HOWEVER, the tax deductible on “discount amortization” has increased, resulting in an overall DECREASE in the “equivalent effective annual interest rate” for BOTH (bond and warrants issue), from 24% to 20% (see my excel file)
Without taking tax deductibility into consideration, it appears that it doesn’t matter what is the “proportional mix” or made up of the subscription price of RMB 100.5 million between bond and warrants - for whatever proportional mix ( 1: 0 or 2/3 : 1/3), the total combined subscription price that Eratat would get is fixed at RMB 100.5 million – no more or no less – it would not change.
However, once tax deductibility is taken into consideration, and depending on the allowable accounting and tax treatment for the bond/warrants issue, “proportional mix” seems to have bearing on the amount of tax payable (or deductible) by Eratat – hence the “equivalent effective annual interest rate” on the bond/warrants issue – if one choose to measure it this way.
As always, an analysis is just as good as its underlying assumptions. Until we know the exact breakdown of the total subscription proceed of RMB 100.5 million between Bond and Warrants, and/or its relevant allowable accounting and tax treatment, honestly, I do not know how to work out the “equivalent effectively annual interest rate” of the “Bond AND Warrants Issue” combined– neither could I work out the “effective annual interest rate” of the “Bond issue” alone.
SPB = RMB 100.5 million and SPW = zero, is only one of the many possible scenario.
Comments are most welcomed.
Research, research and research - Please do your own due diligence (DYODD) before you invest - Any reliance on my analysis is SOLELY at your own risk.