Hallow Products has been in business for quite a while. Its shares trade on a public exchange and it is thinking of expanding onto the New York and London stock exchanges. Recently, however, the company has run into cash flow difficulties. The CEO is confident that the company can overcome this problem in the longer term as it has a solid business model; however, in the shorter term Hallow needs to be very careful in managing its cash flows, of particular concern is the fact that it has multiple potential common shares outstanding that cause the diluted earnings per share numbers to be significantly lower than the company's basic EPS. This in turn has recently caused Hallow's stock price to decline and is affecting the company's ability to get the best interest rates on its bank loans.

At a recent meeting with the CFO, the CEO decided to exchange the company's convertible senior subordinated notes (the old notes) for new senior subordinated notes (the new notes). The notes were held by a large institutional investor that agreed to the exchange. The old notes were convertible into 25 shares for each $1000 note. The new notes have a net share settlement provision that requires that, upon conversion, the company will pay the holders up to $1000 in cash for each note, plus an excess amount that would be settled in shares at a fixed conversion price (30 shares for each $1000 note in the total consideration). The notes may only be turned in if the share price exceeds 20% of the fixed conversion price.

It is now year end and the share price is trading above the fixed conversion price but well below the 20% premium level. The note therefore cannot be tuned in (i.e., converted). The CEO feels that the share price will not exceed the 20% premium for a couple of years.

Instructions

Adopt the role of the auditors and discuss the issues related to the new notes.