America Online 2014 Annual Report Download - page 107

AOL INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
occurrence of certain events in the future, as defined in the Indenture. On or after May 1, 2019 to the close of
business on the second scheduled trading day immediately preceding the maturity date, holders may convert all
or any portion of their Notes, regardless of the foregoing conditions. The Company’s intent is to settle the
principal amount of the Notes in cash upon conversion. If the conversion value exceeds the principal amount, the
Company would deliver shares of its common stock in respect to the remainder of its conversion obligation in
excess of the aggregate principal amount (the “conversion spread”). The conversion spread would be included in
the denominator for the computation of diluted net income per common share, using the treasury stock method.
As of December 31, 2014, none of the conditions allowing holders of the Notes to convert have been met.
Accounting guidance requires that convertible debt that can be settled for cash, such as the Notes, be
separated into the liability and equity component at issuance and each be assigned a value. The value assigned to
the liability component is the estimated fair value, as of the issuance date, of a similar debt without the
conversion feature. The difference between the principal amount of the Notes and estimated fair value of the
liability component, representing the value of the conversion premium assigned to the equity component, is
recorded as a debt discount on the issuance date. The fair value of the liability component of the Notes was
determined using a discounted cash flow analysis, in which the projected interest and principal payments were
discounted back to the issuance date of the Notes at a market yield, and represents a Level 3 fair value
measurement. The Company estimated the straight debt yield by modeling the convertible note as a combination
of a straight debt and a European call option. This required the use of a combination of inputs for similar assets
observable in the marketplace to determine a yield on similar instruments without a conversion option and a
significant unobservable input to estimate the future volatility of the Company’s stock. The Company’s stock
volatility was estimated at 40% based on historical AOL stock price volatilities, as well as implied volatilities
from option contracts traded immediately prior to the issuance date of the Notes. The Company estimated the
straight debt borrowing rates at issuance to be 5.39% for similar debt to the Notes without the conversion feature,
which resulted in a fair value of the liability component of approximately $301.5 million and a debt discount of
$78.0 million. As a result, a conversion premium of $45.6 million, net of tax, was recorded in additional paid-in
capital within stockholders’ equity. The debt discount is amortized to interest expense using the effective interest
method with an effective interest rate of 5.85% over the period from the issuance date through the contractual
maturity date of the Notes on September 1, 2019.
In accounting for the transaction costs related to the Note issuance, the Company allocated the total amount
incurred to the liability and equity components based on their relative fair values. Issuance costs attributable to
the liability component were recorded within other assets on the consolidated balance sheets and are being
amortized to expense over the term of the Notes using the effective interest method. Issuance costs attributable to
the equity component were recorded as a charge to additional paid-in capital within stockholders’ equity.
Balances attributable to the Notes consist of the following (in millions):
December 31,
2014
Liability component:
Principal .................................................................... $ 379.5
Less: note discount ............................................................ 73.0
Net carrying amount ............................................................... $ 306.5
Equity component* ................................................................ $ 75.8
(*) Recorded on the consolidated balance sheets in additional paid-in capital within stockholders’ equity.
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