Implication of Business Market Alpha ltd Plans

Question: 1 . (a) Alpha Ltd plans to issue 1 000 bonds that have a face value of $100 and 8 years to maturity. The bonds pay a coupon rate of 8%, paid every six months and offer the same yield as that of similar-risk companies, i.e. 2% higher than the government bond rate of 5.5%. The potential investors are offered the option to convert each bond held into Alpha s ordinary shares that are expected to pay a dividend of $1.50 per share in the next year. These dividends are expected to grow at 7.5% every year. Assume you are a potential investor and shares in companies with similar risks to Alpha Ltd are currently trading at a nominal discount rate of 10% per annum. Calculate the value of the bond and the share. Discuss whether you should accept the option to convert Alphas bonds into its ordinary shares. (12 marks) b) Discuss the implication of term structure of interest rates on investors preference for a short-term bond over a long-term bond. Assuming both bonds have the same face value and pay the same coupon rate. (13 marks) 2 . a) Cantona Ltd plans to expand its production capacity by purchasing an additional machine that costs $3 600. The company will incur $750 shipping and $450 installation costs. The machine is expected to have a useful life of five years with an annual depreciation of $400. At the end of the 5th year, the machine will have a book value of $1 600 and can be sold at the market value of $1 200. Cantona forecasts $2 800 additional revenues per annum generated, and $200 additional costs per annum incurred by the machine. The companys tax rate is 30% and its cost of capital is 10%. Determine the net present value of the cash flows associated with the machine. b) The net present value (NPV) rule often provides the most correct investment decision. Discuss whether you agree with the above statement. 3. Distinguish between debt financing and equity financing. Your response should include a discussion on when to use debt financing or equity financing. Answer: 1. Valuation of share It is known that shares with similar risk profile have an expected return on equity of 10% pa. The Alpha ordinary share would pay a dividend of $ 1.5 next year and it would increase perpetually at the rate of 7.5% per year. As per Gordon dividend discount model (Damodaran, 2008). Price of share = Next Year Dividend/(Required return Dividend growth rate) Hence, price of ordinary share of company = 1.5/(0.1-0.075) = $ 60 Valuation of bond Face value of bond = $ 100 Coupon rate = 8% paid semi annually Hence, coupon payment after every six months = 0.08*100/2 = $ 4 Time to maturity = 8 years Prevalent market interest rate which would act as discount rate = 5.5 + 2 = 7.5% pa Hence, the value of the bonds can be estimated from the following table (Petty et. al., 2015). Half year Total cash inflow Present value factor PV of cash inflow ($) 1 4 0.9639 3.86 2 4 0.9290 3.72 3 4 0.8954 3.58 4 4 0.8631 3.45 5 4 0.8319 3.33 6 4 0.8018 3.21 7 4 0.7728 3.09 8 4 0.7449 2.98 9 4 0.7180 2.87 10 4 0.6920 2.77 11 4 0.6670 2.67 12 4 0.6429 2.57 13 4 0.6197 2.48 14 4 0.5973 2.39 15 4 0.5757 2.30 16 104 0.5549 57.71 Total 102.97 Thus, the current value of one bond of the company is $ 102.97 Decision to convert or not Since the intrinsic value of the ordinary share of the company is $ 60 which is significantly lower than the amount recovered from the bond in terms of repayment, thus, it is beneficial for the investor not to go for the conversion of the bond into one equity share of the company (Brealey, Myers Allen, 2008). The term structure of interest rate also referred to as yield curve and may take various shapes. However, normally the interest rates or yield tends to increase as the maturity increases as the underlying risk increases, thus resulting in addition of maturity premium. There are three main theories that tend to impact the structure of interest rate which in turn drives the preference of investors (Parrino Kidwell, 2011). Pure expectation theory This tends to state that the yield curve is driven by the expected interest rates in the short run. For instance, if the investors expect that in the long run that the interest rates would fall, the same would be built up in the yield curve and represented. However, this theory ignores the importance of maturity premium. Liquidity preference theory The investors tend to demand compensation for the higher interest rate risk in the long run. Also, they tend to prefer bonds with lower maturity as the underlying interest rate risk is lesser and can be predicted with more accuracy. Market segmentation theory This deals with the underlying demand and supply of bonds of a particular maturity and in the event the investor should invest in a maturity period which is not preferred by him/her, then suitable compensation should be given to the investor. Assuming that the face value and coupon rate is same, the investors would prefer short term bonds compared to long term bonds due to the following reasons (Brigham Ehrhardt, 2013). The expected interest rate in the short term can be predicted with more accuracy. In case of higher maturity period, the underlying interest rate risk may increase. As a result of higher interest rate fluctuations, the price of the bond may fluctuate and hence limit the liquidity associated with a bond. For instance, if the market interest rates rise, the bond prices would fall and hence the investor may have to hold the bond till maturity which would enhance liquidity risk. Considering the volatile financial markets, a low maturity period offers flexibility to the investors in terms of switching amongst asset classes based on performance. In case of low liquidity for certain bonds, the liquidity premium may also be applicable for longer maturity bonds. However, since the coupon is same, hence the investor would like to minimise the liquidity risk by choosing a lower maturity period. 2. Total cost of the machine = 3600 + 750 + 450 = $ 4,800 The NPV calculation based on the incremental cash flows arising from the project are shown below (Brealey, Myers Allen, 2008). Year 0 1 2 3 4 5 Incremental revenue ($) 2,800 2,800 2,800 2,800 2,800 (-)Incremental cost ($) 200 200 200 200 200 (-)Annual Depreciation ($) 400 400 400 400 400 (-) Cost of machine (including shipping and installation) 4800 (+) Salvage value of machine 1200 Pre-tax cash inflow/(outflow) -4800 2200 2200 2200 2200 3400 (-)Tax (@ 30%) 660 660 660 660 1020 Post tax cash inflow/(outflow) -4800 1540 1540 1540 1540 2380 (+) Depreciation (since non-cash charge) 400 400 400 400 400 Net cash inflow/(outflow) -4800 1940 1940 1940 1940 2780 (*)PV Factor (@ 10% discount rate) 1 0.909 0.826 0.751 0.683 0.621 PV of cash inflow/(outflow) ($) -4800 1763.64 1603.31 1457.55 1325.05 1726.16 NPV ($) 3075.70 As is apparent from the above calculation, the NPV associated with the machine is $ 3,075.7. I would agree with the statement that NPV often gives the most correct investment decision. This is primarily because the other techniques deployed for capital budgeting have shortcomings that are listed below (Damodaran, 2008). Payback period does not take into consideration the time value of money and also does not consider the cash flows after the payback period. Discounted payback period does not consider the cash flows arising from the project after the discounted payback period. IRR or Internal rate of return may not give accurate result in cases where cash outflow in involved during the project. This usually gives rise to multiple IRR values. NPV does not suffer from any of the above issues identified with commonly used techniques. However, it is quite sensitive to the discount rate but that is also true for the other techniques which take into consideration the time value of money. Thus, NPV is undoubtedly a correct technique and can also be used for choosing between mutually exclusive projects (Parrino Kidwell, 2011). 3. Debt financing refers to the financing arrangement where the money is raised in the form of debt and not equity. On the other hand, equity financing refers to the financing arrangement where the money is raised in the form of equity and not debt. Advantages of debt financing Since the equity is not diluted, hence ownership and control is maintained. Due to the interest charges, tax liability is reduced. The company has flexibility to borrow based upon underlying use. Disadvantages of debt financing There is significant bankruptcy risk since the borrowed sum needs to be repaid back with interest. It tends to reduce the flexibility available to business due to debt covenants imposed by lenders. The profitability may take a hit due to continuous interest payments especially in times of weak business environment. Advantages of equity financing The money raised does not need to be repaid back. No strict covenants associated and higher overall flexibility in business. No bankruptcy risk as no interest or principal repayment. Disadvantages of equity financing Since equity is diluted, hence ownership and control reduces which may make it difficult for the promoter to run the business as consultations from shareholders would be required before critical decisions are made. Investors typically demand a higher rate of return on equity as compared to debt. Raising equity especially through capital markets may be time consuming and tedious affair. Equity financing or Debt financing It is apparent from the above discussion that both debt financing and equity financing have their relative merits and demerits. As a result, it is imperative that companies should use a judicious mix of these two modes of financing so as to derive an optimum capital structure. The exact mix of the two financing would depend on a plethora of factors such as size of the company, nature of the business, amount of money required, amounts of profit generated, robustness of business model and underlying economic climate (Brealey, Myers Allen, 2008). For instance, when the company is small and in its nascent stages, then equity financing is comparatively more preferred since such companies do not have assets to keep as collateral for availing debt financing. Further, in sectors such as infrastructure where capital requirements are huge, debt financing is more preferred compared to equity financing. Besides, in businesses and projects that are highly risky, more equity financing is preferred as the banks and financial institutions are unwilling to lend (Petty et.al., 2015). Thus, from the above discussion it may be concluded that the preference of debt or equity financing is driven by a plethora of factors and usually a mix of both modes is used with varying degrees as demonstrated using examples above. References Brealey, R, Myers, S Allen, F 2008, Principles of Corporate Finance, 9th eds., McGraw Hill Publications, New YorkBrigham, EF Ehrhardt, MC 2013. Financial Management: Theory Practice, 14th eds., South-Western College Publications, New YorkDamodaran, A 2008, Corporate Finance, 2nd eds., Wiley Publications, London Parrino, R Kidwell, D 2011, Fundamentals of Corporate Finance, 3rd eds., Wiley Publications, London Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD Burrow, M 2015, Financial Management: Principles and Applications,6th eds., Pearson Australia, Sydney