The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives - Assignment Example

Finance Assignment Introduction Car Tracker is a well known company of its kind that is engaged in the business of GPS systems which are able to track the manoeuvre of vehicles that ply on the roads of a city. The development of the system requires essential skills of engineering and technology along with a continuous investment in research and development so that the system remains up graded to the standards of the recent times. Hence this kind of an investment is a very essential part of the business. Background of the company’s financials The significant information that is available for the company can provide an insight about the existing financial health of the company. In order to fund its investment needs the company has gone to the public and listed its share in the Australian Stock Exchange. The shares were issued at $1 and were listed at a premium. Over a period of time the price of the shares declined due to a host of factors like a lot of new entrants in the same industry and hence the demand for the shares of this particular company going down. The company has to increase its Earnings per share as well as the profit because they have to incur a lot of expenses on the R & D activities which the company cannot avoid. This is essential for the company to sustain in the long run. The company has a debt-equity ratio of 1.25, which means that the capital structure of the company is composed of both debt and equity and they are approximately in the proportions of 55% and 45% respectively. The permissible level of this debt and equity proportion can be extended up to 56.5% and 43.5% respectively. This means that there cannot be much change that can be made to the capital structure of Car Tracker. This flexibility has been approved by their trust deed. Financing for the Investment Project The company at present intends to invest in a high tech digital investment that would be financed over a period of one year. The company needs to look for the investment options that are available to the company and the prospects of each of the option. However, prior to this process, it is important to analyse the type of the investment that the company is going into. Type and Feasibility of Financing the Project The company has a motive of undertaking a capital expenditure that would generate return for the company in the long run. The company would set up a high tech project that would need resources and hence would require a capital for the establishment. This kind of project would need a huge initial investment and also smaller investments on a continuous basis for a period of one year till the project starts generating returns to the company and the investors. Undertaking this kind of a project would also keep the company up graded with the latest technology, make their products more acceptable to the customers, retain and amplify the customer base and enhance the brand image and thereby add to the goodwill of the company. To understand the viability of the project the Net Present Value and the Payback Period needs to be analysed for knowing how much return it would generation after the completion of the establishment project and the Payback period for the project because the project has to be continuously financed for one year since its inception. For the initial year this particular project would not be able to generate any return to the investors (Gallagher 95). This will start only after the completion of the project and as a result of this the financing option should be such that there is a time cushion available for the company for serving the liabilities. Simultaneously the Internal rate of return has to be found out in order to know how much the company can pay back to the entity that would come forward for financing the project. The company needs to retain a sufficient amount of earning after paying back to the debtor because otherwise the Earnings per share for the company would face a decline and the company would lose its shareholders and the price per share would diminish. Hence these are some of the factors that the company management has to be aware of before opting for a particular financing plan. The financing options open to Car Tracker There are a number of options that are available to this company for the funding of the investment project. It is necessary to analyse the positive and negative sides of all these options. Non Voting Redeemable Preference Shares It is a form of financing where the capital is of a hybrid characteristic. The capital possesses features of both debentures and equity. The similarities with equity lies in the fact that the return that is provided to the preference shareholders are paid out only after fulfilling the other obligations and the profit that remains gets distributed. It is not tax deductible as in case of bonds or debentures. The payment has to be done to the preference shareholders only after meeting the necessary obligations but there is no obligation on part of the company to pay the dividends. It resembles a debenture in a way that the rate in which the dividend would be paid out is predetermined and the capital can be redeemed. For opting for this kind of financing method the advantage for Car Tracker would be that the company would not be able to pay the preference dividend for the initial one or two years. But it would not be an obligation for the company to make such payment (Heinkel 2). Hence there is no chance that the company would face any kind of bankruptcy risk when going for this financing option. Since there would not be any kind of voting right for the preference shareholders, hence Car Tracker would be able to retain the control over the company with the present management set up. The company also does not have to keep any of its assets as collateral in this case of financing. The net worth of Car Tracker would increase and thus the prices of the shares in the stock markets would rise. However, Car Tracker may face several problems while opting for this policy. Financing through issue of preference shares is not as economical as that of debt because in case of debt the company would have got a deduction in the taxes but this would not happen in case of preference shares. The company may not be legally penalised for not paying the dividend payments to the preference shareholders but it would send a negative signal about the brand Car Tracker in the securities market and the share prices would face a decline. Revolving 90-Day Bank Bill Facility This kind of bill discounting or overdraft facility will enable the company to get cash from the bank however for this the company has to keep a sufficient amount of collateral with the bank which may not be possible for the company at present. This would be an ideal form of working capital financing for the company and most of the companies go for this method to meet their working capital needs. However in this particular case Car Tracker seems to be going for certain capital expenditures and it would need a fund that would be floated for a longer term. Hence these short term financing needs would not be suitable for the one year project that the company is heading towards. Rights issue for Car Tracker in the Australian Securities Exchange The rights issue is a form of financing where the company may issue shares to the already existing shareholders in the equitable proportion as the already hold. Thus the existing shareholders only get the right to avail this share. The advantage of this option would be that since only the existing shareholders would be approached, the advertising and other operational expenses would be much less than what it had incurred during its initial public offering or it would face if it issues a follow on public offer. However, this may have its disadvantage for the Car Tracker because the share prices have already declined if they go for this method the prices may fall further. The shareholders may not be interested to go for the rights issue if any new company in the present scenario is planning to launch its IPO. Again in most of the circumstances a rights issue is made to the public at a price that is generally lower than the previous public issue. As a result of this the EPS of the company would tend to fall. Maintaining a Current Ratio of 2.5 The ratio of current assets to current liability for the company has to be maintained at 2.5. This means that the company has to maintain a much greater short term solvency and has to increase the proportion of its current assets. Most of the current assets would include cash, debtors and short term loans. For this most of the earnings of Car Tracker has to be maintained in form of liquid assets and not to be invested in any kind of capital expenditure (Weston 295). This kind of a current ratio is most difficult to maintain for a GPS manufacturing company because the company would have several creditors and other short term cash needs and the fund kept in liquid form as this would not be channelized properly. Loan from West Bank for 10 years at a floating rate of interest The advantage of taking a loan from a bank for a 10 year period is that the company can get the fund initially in a lump sum form as well as small amounts as and when required. The bank can disburse the funds as per the needs of the company. Car Tracker can get an advantage on tax point of view because the interest on the loan would be a tax deductible expense. The managerial control would also remain in the hands of the existing board of directors. The operational costs of debt financing are also considerably less compared to the other forms though the Bank approving the loan has to undertake a thorough appraisal process. The disadvantage of taking a floating rate loan from West Bank is that the interest rate may go up in future and it may be very high. Thus the company may face a lot of debt burden and may be unable to serve it in future. The Bank may also be apprehensive about the future stability of the company and may not be willing to forward the loan for such a long term of 10 years. The company has to maintain a very good credit history and strong financial fundamentals in that case. Approaching Wilson Growth Fund Manager for Private Placement of Ordinary Shares Car Tracker may look for an option to approach the Wilson Growth Fund Manager to act as a mediator in selling the shares to their existing clients. These shares would be ordinary equity shares that the company would issue but it would be privately placed and would not be available to the general public (Rosenbaum 134). Thus the floatation cost would be much lower compared to public issue. The disadvantage of Private Placement is that Wilson Fund would provide the shared to only those who they wish to and hence it would lead to a concentration of power among a few shareholders which may impact the company management later. Approaching four banks for a Consortium Loan Car Tracker is investigating the prospects of going to ANZ Bank, Macquarie Bank, Commonwealth Bank and National Australia Bank for the loan for financing the project. This arrangement can be adopted by the company if the company intends to take a very large sum of money as a long which cannot be financed by one institution alone. The advantage is that the principal can be disbursed in the same proportion by all the four banks and thus all the banks can act in a competitive way which is advantageous for Car Tracker. The loan is also structured very well. The disadvantage is that if the company cannot repay the loan it will become a non performing asset for all the four banks and so unless the company has very good financial position none of the banks would come forward to give such a kind of loan. Going for an interest rate Swap Contract with Alpha Hedge fund at a fixed rate of 9% per annum The company may have a credit history such that West Bank is willing to provide loans to Car Tracker only at a floating rate of interest. But the company feels that the interest rates would go up in future and so going for such a scheme would increase his debt financing expenses. The company in such circumstances can go for a Swap Contract at fixed 9% rate of interest for which the yearly obligation for the company would remain at a constant rate. Thus the company would get an advantage on the terms of payment of interest due to the mutual exchange in the contract terms with Alpha Hedge Fund. However, the company would be exposed to a lot of risk if it goes for such a speculative way of investment. Also if the interest rate comes down in future to a much lower level then the company would still have to pay the high rate to the bank. Hence this can be adopted only if the company is sure about the increasing rates of interest in future. Recommendations All the above discussed procedures have their merits and demerits. However for Car Tracker the most rational and practicable option would be to go for a mixed contract whereby Car Tracker would go for a 10 year term loan from the bank for meeting its capital expenditure needs and would take a 90 day Bank bill facility for meeting its short term requirements. However, the same bank may not be willing to provide both of these facilities. If we assume that the company has very good fundamentals and it would expand its debt equity ratio to 1.3 then Car Tracker can go for the extra 1.5 % as loan and the remaining can be taken through this bill discounting method (Modigliani 268). The issue of preference share could also be a feasible way, provided the company gets enormous returns at the end of the one year period so that it can provide necessary dividends to the preference shareholders. This would be an expensive option for Car Tracker but keeping in mind the new technology and its acceptability among customers it is expected to get good returns for the company. To sum up the company can go for any of the above process provided it keeps its working capital requirements intact and maintains the desired Debt-Equity Ratio. References Gallagher, Timothy. Financial Management. Englewood Cliffs: Prentice Hall. 2003. Print. Heinkel, Robert and Josef Zechner, J. The Role of Debt and Preferred Stock as a Solution to Adverse Investment Incentives. Journal of Financial and Quantitative Analysis. Vol.25 (1). 1990. Print. Modigliani, Franco and Merton Miller. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review (American Economic Association). Vol.48 (3). 1958. Print. Rosenbaum, Joshua and Joshua Pearl. Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions. Hoboken, NJ: John Wiley & Sons. 2009. Print. Weston, J. Fred. Essentials of Managerial Finance. Hinsdale: Dryden Press. 1990. Print. Read More