Cash Budget of Star Bay - Assignment Example

Case Study of Star Bay Answers: 1a) I would not completely disagree with the decision taken by Thomas McGill of raising the funds by issuing non-convertible bonds and equity, rather I would recommend an alternative solution of raising the funds by issuing from all the three components i.e. $10 million from non-convertible bond, $5 million from commercial paper and the rest by selling the common stock. As we already know the industry average debt ratio is 38 and 30 of SBC, so we can increase our debt ratio by raising funds by issuing debts as the debt ratio of SBC is low as compared to the industry average. So, if we assume that total assets of the company is $100 million as the total assets of SBC was 148 million in 1999 assuming the growth rate of 5%, at the present time the debt will be $30 million, so we can raise additional $8 to $10 million by issuing debt and it will increase the leverage of the company. As the EPS (Earning per share) is 1 and the price of the stock is $10 the total number of shares would be 6 million, so the earning would be 6 million as the EPS is 1. As our stock is under priced as compared to the industry average and even the cost of equity is always high as compared to cost of debts, the equity components is low as compared to the debt component and equal to short term lending and it will not have a major impact on the EPS of the company. The burden of the interest will also be taken care of by this pattern of funding as the interest rates are not too high even though the company’s R&D costs were high during that period and start-up costs of the new facilities were not offset by increased revenues. Earnings per share = Total earnings/Number of shares. 1b) Quarterly cash budget for the year 1992 (000$). Particulars Quarter 1(91) Quarter 2(92) Quarter 3(92) Quarter 4(92) Opening bal of cash: 6000 -4100 -22100 -25100           Collection from debtors 21000 29000 44000 51000           Total 27000 24900 21900 25900           Less :         Payments to Creditors 22500 37500 37500 45000           Expenditure 3600 4500 4500 5200           Min Requirement of cash 5000 5000 5000 5000 Closing bal -4100 -22100 -25100 -29300 As we can observe from the above cash budget that the estimate made by Thomas McGill that the Star Bar Company doesn’t require additional funds from external source to finance its operations internally is incorrect. The decision taken by Thomas McGill of Cash merger and raising funds by issuing long term loan would further increase the company’s expenditure owing to the interest and thus, increase the deficit in cash as the company already is suffering with deficit. In late 1990’s, we already raised funds by issuing debts, which increased the debt ratio as compared to industry average. Hence, I would recommend acquiring MHP by selling the stock worth $25 million instead of cash merger. The EPS of the SBC would not have major impact if MHP is acquired by selling the company’s stock to the MHP instead of paying cash by borrowing from external source and increasing the deficit as shown below. The following is the Cash Budget of the Company after taking the loan. Quarterly cash budget for the year 1992 000$. Particulars Quarter 1(91) Quarter 2(92) Quarter 3(92) Quarter 4(92) Opening bal of cash: 6000 -4100 -22413 -25726           Collection from debtors 21000 29000 44000 51000           Total 27000 24900 21587 25274 Less :         Payments to Creditors 22500 37500 37500 45000           Interest @ 5%   313 313 313           Expenditure 3600 4500 4500 5200           Min Requirement of cash 5000 5000 5000 5000 Closing bal -4100 -22413 -25726 -30239 Long term loan 25000 Interest @ 5 % 1250 Quarterly 313 1c) I would agree with the decision made by Thomas McGill of dropping the idea of retiring debt in the current scenario. As in the current scenario interest rate of the commercial paper is 4.5% and that of long term debt is 5.00% and as per the opinion of analysts and Wall street experts, the interest rate are going to increase in the near future leading to high interest rates as compared to long term debt, which is not convincing. Even borrowing short term debt would lead to finance requirement within a year to repay the short term debt as compared to long term debt which is not required to be repaid within a year. Even short term debts are not borrowed to repay long term debt as they are borrowed to finance day to day working capital requirement. 1d) I agree with the decision made by Thomas McGill of raising funds by issuing convertible bonds as the interest rates are low in comparison with short term debt and non-convertible bonds and also it can be seen that currently our debt ratio is 35 as compared to industry average which is 37 and also by raising the funds through issue of debt will increase the debt ratio more than the industry average, so by issuing convertible bonds which can be converted into equity in near future will reduce debt ratio below the industry average. Non-convertible bonds cannot be converted into equity in near future as compared to convertible bonds; therefore, issuing funds by nonconvertible debts is not convincing. The company would require additional funds to repay the short term debt within a year as compared to convertible, which require to be repaid within a year and hence, issuing short term debt for funds is also not a good idea. Raising funds by selling the stock at this time will reduce earnings per share; wherein issuing convertible bonds will not have any impact on earnings per share. 1e) The idea of repaying the short term through long term debt is logical as the interest rates are expected to increase due to inflationary pressures. The idea behind repaying the short term debt was strengthening company’s position and mitigating the risks of fluctuating interest rates of short term debts. So, the decision taken by Thomas McGill to repay the short term debt by issuing non-convertible bonds will help the company to not only mitigate the risks of fluctuating interests but also the pressure of raising additional funds to repay short term debt at regular intervals. 1f) Calculation of Present value of Cash Inflow: As per Note 4 Total P.V Of cash Inflow 20,554,189.41 Calculation Of Net present value If borrowing at 8 % Total P.V Of cash Inflow 20,554,189.41 Total P.V Of cash Outflow 17,551,307.37 Net Present Value 3,002,882.04 If borrowing at 9 % Total P.V Of cash Inflow 20,554,189.41 Total P.V Of cash Outflow 18,780,220.79 Net Present Value 1,773,968.62 If borrowing at 10 % Total P.V Of cash Inflow 20,554,189.41 Total P.V Of cash Outflow 20,009,134.21 Net Present Value 545,055.20 The expansion project is showing a positive NPV, which is calculated as above at different interest rates. I would rather have slight disagreement with the decision made by Thomas McGill of not expanding its present facilities to cope up with continuously increasing demand of its product as per the NPV calculation. Even if the interest rates increases due to inflation and rises up to 10% in near future, it would show a positive NPV. So, on the basis of NPV, I would have gone for the expansion in order to increase profits. However, as we already know that our debt ratio is higher than industry average and is expected to further increase the debt ratio and expenditure owing to interest and making the company highly levered if we go for the expansion by raising funds through borrowings from external sources. The decision taken by Thomas McGill also considers fiscal and the monetary policies of government, which indicates that the economy will go into recession and expected income will not be generated by expanding the project as expected. The NPV will be negative leading to fall in the total earnings of the company. Hence, I would agree with the decision made by Thomas McGill of dropping the idea of Expansion. 1g) The decision made by Thomas McGill of raising funds by selling a 25 year bond at floating rate set at three quarter of 1% above the prime rate is justified. The difference between the interest as per floating and fluctuating rates is 1% but in terms of amount, the difference is $200,000. Interest as per floating rate is low as compared to fixed rate of interest and I believe that the prime rate is at its peak or maximum to maximum it may increase to 9 due to the inflationary pressures. 2) I believe that the decision made by Thomas McGill are improving over time as can be seen from past records and as per my evaluation, his decision taken in different years as shown above. 3) If I were George Teel, head of the consultant’s team, my opinion would be more or less in favor of Robert’s approach as he was successful in expanding a small manufacturing company to a considerably profit oriented organization and was also able to create decent creditworthiness for the company. On the basis of which, he successfully borrowed funds from market and recommend the following in the future for continued growth. The major recommendations are: The policy of the company of investing its earnings back in the market instead of distributing as dividend to its stockholders should be addressed upon and the stockholders should also be benefited by a high percentage of dividends irrespective of reinvesting the earnings into market. Thomas McGill has successfully raised funds from external sources in past, but now it is recommended to change the policy of raising funds from external sources and instead, raise funds by selling the company stocks, as it would reduce the interest expenditure and would not only help to raise huge amount of capital in short period but also spread the risk of business. Though debt is cheaper, it is riskier due to an obligation to pay back the interest on debt and debt amount irrespective of making profit or loss. But dividends to the equity shareholders will be distributed only if company makes profit. The market value of equity rises if a business does well and has a robust future outlook. This leads to the promoter holding and multiplying in value, though it is notional to a great extent. In times of need, the promoter can sell part of his stake in business by offloading 5-10% equity to raise cash. The same though, can’t be said about debt. Even the EPS would increase as the earnings would increase due to reduction in interest expenditure. Appendices: Read More