On 1 July 2021 Scarecrow Ltd issues convertible notes with a face value of $6 million. The convertible notes have a 20-year term and mature on 30 June 2041. Interest is payable semiannually in arrears, on 31 December and 30 June each year, and the coupon rate of interest is 7.5% p.a. At around the same point in time, companies with a similar credit rating issue debt securities without a conversion option with a coupon rate of 10% p.a., payable semiannually.
1. Explain why the coupon rate to holders of the convertible notes is less than the rate of return offered to investors in the debt securities of other similar companies.
2. Determine the debt and equity components of the convertible notes issued using the residual valuation method.
3. Prepare the entries of Scarecrow Ltd to account for the convertible notes over the period 1 July 2021 to 30 June 2024.
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