Dissertation on Finance
The proposed acquisition of land by HRI does not seem to fit the original business pattern of HRI as it was set at inception of the company. As the case states the founder of the company engaged HRI in the purchase of underdeveloped acreage, which was then developed, for industrial use. In addition it is stated that the company’s plan from inception had been to deal in only the most potentially profitable land acquisitions. The acquisition of new property seems to in line with the company’s business plan, but since the case explicitly states that it likes to buy undeveloped property, this new proposed purchase might be out of line with the original intentions of the company’s founder. If however the new property is fairly priced as the case states that it then the company may make a wise business decision to buy even though the property is already developed and is currently occupied by a well-built office building. The forecasted increase in EBIT looks attractive at 20%, which might also make the decision a bit easier to make.
2. If HRI uses debt to finance the new acquisition of property then the company may increase the current debt ratio. This increase in the debt ratio could hurt HRI’s triple A rating with bond rating companies, which could in turn drive up the required coupon rate that investors will want in order to supply the capital that HRI needs. The new bond issue will affect the company’s income statement as shown below modified from the example in the case. The case states that their will be an increase in EBIT of 20%.
EBIT $5,292,840
Less: Interest (2,795,000)
Taxable income $2,497,840
Less: Taxes (30%) (749,352)
Profit after-tax $1,748,488
The second option given to the company is a stock offering of 200,000 shares of common stock, which the company will net $30 per share. Issuing common stock has its advantages. No interest payments to make and possibly no downgrade in the company’s rating. In issuing common stock the company will have a new set of challenges to face. First the company must decide what the investors required return will be and then HRI must ensure that it earns an adequate return on it’s assets in order to compensate the investors. HRI must make decisions regarding dividend policy, and must ensure that an adequate amount of growth takes place in order to keep shareholders happy. The third option that the company has is to offer preferred stock at a net to the company of $93.50. This would have the company issuing about 64,171 new shares of preferred stock. With preferred stock yield of 8% HRI will have a mandatory dividend payment to make. This dividend payment would not be tax deductible like the interest payments on a bond issue. The company may wish to offer cumulative preferred to ease investors or, the shareholders may want other provisions that protect their equity investment in the company which might restrict some capital budgeting decisions of the company. Because of the current income offered to shareholders who own the preferred shares the stock can be sold at a premium, there by reducing the total amount of shares issued, which can serve to protect against diluting the equity interests in the company. Given the three financing options available I would choose the bond issue and make them callable to take advantage of downward swings in interest rates. I would also be drawn towards the tax shield available through the bond issue.
__________________________________________________________2. If HRI uses debt to finance the new acquisition of property then the company may increase the current debt ratio. This increase in the debt ratio could hurt HRI’s triple A rating with bond rating companies, which could in turn drive up the required coupon rate that investors will want in order to supply the capital that HRI needs. The new bond issue will affect the company’s income statement as shown below modified from the example in the case. The case states that their will be an increase in EBIT of 20%.
EBIT $5,292,840
Less: Interest (2,795,000)
Taxable income $2,497,840
Less: Taxes (30%) (749,352)
Profit after-tax $1,748,488
The second option given to the company is a stock offering of 200,000 shares of common stock, which the company will net $30 per share. Issuing common stock has its advantages. No interest payments to make and possibly no downgrade in the company’s rating. In issuing common stock the company will have a new set of challenges to face. First the company must decide what the investors required return will be and then HRI must ensure that it earns an adequate return on it’s assets in order to compensate the investors. HRI must make decisions regarding dividend policy, and must ensure that an adequate amount of growth takes place in order to keep shareholders happy. The third option that the company has is to offer preferred stock at a net to the company of $93.50. This would have the company issuing about 64,171 new shares of preferred stock. With preferred stock yield of 8% HRI will have a mandatory dividend payment to make. This dividend payment would not be tax deductible like the interest payments on a bond issue. The company may wish to offer cumulative preferred to ease investors or, the shareholders may want other provisions that protect their equity investment in the company which might restrict some capital budgeting decisions of the company. Because of the current income offered to shareholders who own the preferred shares the stock can be sold at a premium, there by reducing the total amount of shares issued, which can serve to protect against diluting the equity interests in the company. Given the three financing options available I would choose the bond issue and make them callable to take advantage of downward swings in interest rates. I would also be drawn towards the tax shield available through the bond issue.
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Some useful information in answering question 2 is the amount of total interest payments that the company will be making with the new bond issue. This tells us additional yearly liability the company must prepared for. The applicable tax rate for the company helps us to calculate the tax shield and after tax liability of interest payments. Information about investor sentiment may also be useful to the company before issuing the bonds. A good economic and industrial outlook will help to know where the economy (interest rates) might be heading. This could aid the company in deciding whether or not to offer callable bonds or preferred stock.
HRI’s total debt to total asset ratio before the acquisition is 47.66% and after the acquisition is 52.94%. The company’s times interest earned ratio before the acquisition is 1.86 and after is 1.89. The calculations are below.
Before acquisition:
Total debt/Total assets = $25,500,000/$53,500,000 = 47.66%
Times interest earned = $4,410,700/$2,375,000 = 1.857
After acquisition:
Total debt/Total assets = $25,600,000/$59,800,000 = 52.94%
Times interest earned = $5,292,840/$2,795,000 = 1.89
The difference in the debt-to-asset ratio result from the greater degree of financial leverage in using more debt financing.. There is only a small increase in the times interest earned ratio. This may not be entirely accurate due to no new information being given in the case regarding cost of sales. I assume that this is worked out since it is suggested that we use the EBIT, which would account for revenue and COGS. The small difference in the times interest earned ratio may be due the difference in increased EBIT and the increase in interest as a result of interest payments (in the case of the debt financing).
A sinking fund provision requires that company’s periodically set aside funds that will be used for the retirement of it’s preferred stock issues. The money is used to purchase the preferred stock in the market or to call the stock. Using a sinking fund with a call provision can effectively place a maturity date on preferred stock, which normally does not have a maturity date. This would have the preferred shares selling at lower yields than preferred shares with no sinking fund provision.
This question is similar to question 2. Information about the flotation costs of the new equity issue would have been helpful. Also industry comparisons would have helped. By comparing certain ratios of HRI to the company’s industry peers we can better assess the health of HRI, especially in the context of the proposed acquisition.
A probability estimate regarding EBIT after the purchase can help create “what-if” scenarios that can help the company see as many possible outcomes as is necessary. The estimates can be based on level of income from rents derived from the building or on the salvage value of the building, possible sale price. A probability estimate after the purchase can help the company gauge when to possibly sell the property or to most efficiently manage the property. For example if the probability estimate tells management that there is 65% chance that increased income generated from the property (the case says the company will keep the property and manage the building) will drop by 25% in fourth year (found from industry forecasts) then the company might know when and how to prepare for a change in the value of the property or cash flow or how to diversify itself so if the possible outcome does occur will have no ill affect to the companies earnings to serve protect shareholders.
Alternatives to financing the new property have been provided. I assume the finance department is aware of the flotation costs, and other issuance costs associated with the new common and preferred stock issues, and other costs data for the debt issue is provided. The investment bankers should provide how the new equity issue might change the EPS of the company’s stock, and perhaps an industry outlook as it relates to the new investment purchase. The bankers could also provide to the company protective provisions that preferred shareholders might want or need in order to invest in the stock. Likewise the investment bankers may act as the bond trustee working with the bondholders and overseeing the relationship between the bondholders and the bond issuer. Then the investment bankers could provide the indenture, which provides the specific terms of the credit, the bondholders’, rights, the issuer’s rights, and responsibilities of the investment banker or bond trustees.
If debt is used to finance the new acquisition then HRI will be dealing with a new total debt to total asset ratio of 52.94%. At the company’s current constraint of a maximum of a 55% debt to asset ratio, the company is left with the ability to have 2.06% in additional borrowing.
The flexibility of financing comes in how easy the company can manage certain requirements of that particular financing such as debt interest payments. The bond issue will legally obligate the company to make interest payments to bondholders. The after-tax cost of debt is 4.90% (7.00%(1 - .30)). The company itself can set the yield on the preferred stock so long as it is in a feasible investment range for investors. The ease at which these requirements can be met can help to define the flexibility of the financing alternative. In these terms the most flexible financing alternative is the common stock issue since HRI does not have pay any dividend if it chooses not to. I would say the most risky financing alternative is the bond issue since a failure to make interest payments may lead to bankruptcy. Also in terms of risk is the probability estimation as it relates to the new investment. For example, what is the probability that the proposed investment will actually increase EBIT by 20%? A probability estimate will show the inherent risk in owning the new property from an investment perspective. In the case of income we can measure in terms of after-tax profits that the company can generate on new assets being purchased with the new financing. Obviously the higher the percentage return on investment the better. How the company’s income will be affected by the new financing is also a major concern; how the new financing alternatives affect the key earnings ratios. This could be called financial risk, which is a direct result of the firm’s financing decision. This risk applies to the additional risk or variability of earnings available to common shareholders, and the additional chance of insolvency to the common shareholders caused by the use of additional financial leverage. In terms of income, business risk is a concern. Business risk refers to the variability in earnings before taxes and interest has been paid. Business risk is a result of the company’s investment decision.
___________________________________________________________
Some useful information in answering question 2 is the amount of total interest payments that the company will be making with the new bond issue. This tells us additional yearly liability the company must prepared for. The applicable tax rate for the company helps us to calculate the tax shield and after tax liability of interest payments. Information about investor sentiment may also be useful to the company before issuing the bonds. A good economic and industrial outlook will help to know where the economy (interest rates) might be heading. This could aid the company in deciding whether or not to offer callable bonds or preferred stock.
HRI’s total debt to total asset ratio before the acquisition is 47.66% and after the acquisition is 52.94%. The company’s times interest earned ratio before the acquisition is 1.86 and after is 1.89. The calculations are below.
Before acquisition:
Total debt/Total assets = $25,500,000/$53,500,000 = 47.66%
Times interest earned = $4,410,700/$2,375,000 = 1.857
After acquisition:
Total debt/Total assets = $25,600,000/$59,800,000 = 52.94%
Times interest earned = $5,292,840/$2,795,000 = 1.89
The difference in the debt-to-asset ratio result from the greater degree of financial leverage in using more debt financing.. There is only a small increase in the times interest earned ratio. This may not be entirely accurate due to no new information being given in the case regarding cost of sales. I assume that this is worked out since it is suggested that we use the EBIT, which would account for revenue and COGS. The small difference in the times interest earned ratio may be due the difference in increased EBIT and the increase in interest as a result of interest payments (in the case of the debt financing).
A sinking fund provision requires that company’s periodically set aside funds that will be used for the retirement of it’s preferred stock issues. The money is used to purchase the preferred stock in the market or to call the stock. Using a sinking fund with a call provision can effectively place a maturity date on preferred stock, which normally does not have a maturity date. This would have the preferred shares selling at lower yields than preferred shares with no sinking fund provision.
This question is similar to question 2. Information about the flotation costs of the new equity issue would have been helpful. Also industry comparisons would have helped. By comparing certain ratios of HRI to the company’s industry peers we can better assess the health of HRI, especially in the context of the proposed acquisition.
A probability estimate regarding EBIT after the purchase can help create “what-if” scenarios that can help the company see as many possible outcomes as is necessary. The estimates can be based on level of income from rents derived from the building or on the salvage value of the building, possible sale price. A probability estimate after the purchase can help the company gauge when to possibly sell the property or to most efficiently manage the property. For example if the probability estimate tells management that there is 65% chance that increased income generated from the property (the case says the company will keep the property and manage the building) will drop by 25% in fourth year (found from industry forecasts) then the company might know when and how to prepare for a change in the value of the property or cash flow or how to diversify itself so if the possible outcome does occur will have no ill affect to the companies earnings to serve protect shareholders.
Alternatives to financing the new property have been provided. I assume the finance department is aware of the flotation costs, and other issuance costs associated with the new common and preferred stock issues, and other costs data for the debt issue is provided. The investment bankers should provide how the new equity issue might change the EPS of the company’s stock, and perhaps an industry outlook as it relates to the new investment purchase. The bankers could also provide to the company protective provisions that preferred shareholders might want or need in order to invest in the stock. Likewise the investment bankers may act as the bond trustee working with the bondholders and overseeing the relationship between the bondholders and the bond issuer. Then the investment bankers could provide the indenture, which provides the specific terms of the credit, the bondholders’, rights, the issuer’s rights, and responsibilities of the investment banker or bond trustees.
If debt is used to finance the new acquisition then HRI will be dealing with a new total debt to total asset ratio of 52.94%. At the company’s current constraint of a maximum of a 55% debt to asset ratio, the company is left with the ability to have 2.06% in additional borrowing.
The flexibility of financing comes in how easy the company can manage certain requirements of that particular financing such as debt interest payments. The bond issue will legally obligate the company to make interest payments to bondholders. The after-tax cost of debt is 4.90% (7.00%(1 - .30)). The company itself can set the yield on the preferred stock so long as it is in a feasible investment range for investors. The ease at which these requirements can be met can help to define the flexibility of the financing alternative. In these terms the most flexible financing alternative is the common stock issue since HRI does not have pay any dividend if it chooses not to. I would say the most risky financing alternative is the bond issue since a failure to make interest payments may lead to bankruptcy. Also in terms of risk is the probability estimation as it relates to the new investment. For example, what is the probability that the proposed investment will actually increase EBIT by 20%? A probability estimate will show the inherent risk in owning the new property from an investment perspective. In the case of income we can measure in terms of after-tax profits that the company can generate on new assets being purchased with the new financing. Obviously the higher the percentage return on investment the better. How the company’s income will be affected by the new financing is also a major concern; how the new financing alternatives affect the key earnings ratios. This could be called financial risk, which is a direct result of the firm’s financing decision. This risk applies to the additional risk or variability of earnings available to common shareholders, and the additional chance of insolvency to the common shareholders caused by the use of additional financial leverage. In terms of income, business risk is a concern. Business risk refers to the variability in earnings before taxes and interest has been paid. Business risk is a result of the company’s investment decision.
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