SBCs 1990 Issuing of Stock and Long Term Loan Financing Decision - Example

THE STAR BAY COMPANY CASE STUDY Name of Student Student Number Department Grade Course Tutor’s Name 1st February, 2011 SBC’s 1990 issuing of Stock and Long Term Loan Financing Decision Assessments. The SBC’s executive vice president finance, Thomas McGill’s decision to seek for external funds in the year 1990 is justifiable. Though the company’s sales had been increasing at 5% rate per year in the earlier periods of the company’s existence, the company’s revenues were mostly used in product research and development. Acquisition of additional funds can be justified on the basis of the company’s expectation of increased revenues since the products had been developed and were accepted in the market so the high cost of R&D programs will be low. McGill’s decision of issuing shares worth $10 million was suitable, however the price at which each share was sold was too low. Each share should have been sold at the stock market price since there were expectations that the earnings per share were expected to rise higher than the current earnings of $1 per share. This would have also resulted into the rising of the share value of SBC. The decision to sell the shares at $9 per share also might have resulted to loss of some contribution, but had the shares been sold at $10, then the company would have earned more revenue from the sales. $1 was lost per each share sold. Acquisition of long term non-convertible bonds worth $10 million was a proper decision made by the top management of SBC. The revenues collected from the sales of the bonds can be invested in purchases of fixed assets unlike the case of commercial papers. The option of raising capital using commercial papers could have been inappropriate since they are normally used for the financing of account receivable, inventories and meeting short term liabilities. Repayment of commercial papers should be within 270 days, but in the case of SBC, it needed a huge amount of money which would have required a long time to repay (Brigham and Ehrhard 626). The decision to acquire non-convertible bonds would not have been the most suitable way to go if the was an option of raising the capital needed using convertible bonds. Non-convertible bonds have a very high interest rate as compared to convertible bonds (Werner 56). SBC’s 1992 Cash Budget and assessment of the Takeover bid Financing Q491 Q192 Q292 Q392 Q492 Beginning cash balance 6000 0 -12100 -10100 -8600 Total sales 21000 29000 44000 51000 54000 Total receipts 27000 29000 31900 40900 45400 Total purchases 22500 37500 37500 45000 22500 Expenditure 4500 3600 4500 4500 5200 Total cash expenses 2700 41100 42000 49500 27700 Ending cash balance 0 -12100 -10100 -8600 17700 The company’s policy to maintain a minimum level of cash at $5,000 was not met at the first four quarters. Since the acquisition of Motor Housing Products (MHP) was fixed assets expenditure, a short term bank loan was inappropriate. On the other hand, SBC would have issued stock valued at $25 million rather than borrowing the amount from the insurance company. If the management of SBC would have issued its shares, then it would have avoided the payment of the loans interest. McGill’s Decision to put off Repayment of Long-term Debt in 1995 The decision of McGill to postpone the repayment of the long term debt was worthwhile, since they had planned to finance the long term loan by issuing of commercial paper. Commercial paper is repaid at the market interest rates, and with the expectation of inflation, the interest rates are most probably expected to go up (Brigham and Ehrhard 626). However, the debt could have been appropriately settled if the company could have been financing the payment with the retained earnings since the inflation will also affect the long term loan interest rates. The initial plan to settle the long term debt using short term debt instruments such as commercial papers is unsuitable. The company’s management could have looked for alternative ways of repaying the long term loans, like avoiding additional long term loans and reducing operating expenditures. McGill’s Decision of issuing Convertible Bonds in 1999 McGill could not have taken the option of acquiring a short term debt at an interest rate of 7.5% while he could have acquired a non-convertible long term bond at the same interest rate. His decision of acquiring the needed finances through issuing of convertible bonds can be justified on the grounds of low interest rate by this option of financing (Werner 56). The main limitation of this option is, the bonds can be converted into shares and this will lead to further lose of ownership by the company’s promoters. However, the issuing of convertible bonds could generate more revenue for the company since it had the lowest interest rate of 6.5% and issuing of common stock would have brought $7 less per share. The 2002 Decision to settle Short-term Loans with Long-term Loans With the inflation expected to go on through out the year 2002, the current interest rate was also expected to rise above the 6% level. McGill would have forecasted the level at which the interest rate would reached its highest pointing before making the decision of retiring shot term loans with long term loans. If the forecast would have predicted that the interest rates would not reach the 7% mark, then it could have been inapt to issue the non-convertible bonds worth $25 million since the company was already in debt. McGill could have looked for other ways of repaying the current debt other than getting into another debt since the future is unpredictable, therefore the inflation may continue for a long time (Solow , and Taylor 142). The decision to retire short term loans with long term loans was inappropriate. The 2004 Investment Decision Net Present Value Year T Cash inflow Rate R+1 R+1^t (NPV) 0 $(12500000) - - $(12500000) 1 $8000000 1.1 1.1 7272727.2727 2 $2500000 1.1 1.21 2066115.7025 3 $2500000 1.1 1.331 1878287.0023 4 $2500000 1.1 1.4641 1707533.6384 5 $2500000 1.1 1.6105 1552312.9463 6 $2500000 1.1 1.7716 1411153.7593 7 $2500000 1.1 1.9487 1282906.5531 8 $2500000 1.1 2.1436 1166262.3624 9 $2500000 1.1 2.3579 1060265.4905 10 $3000000 1.1 2.5937 1156648.8029 The Net Present Value is $6897564.7275, therefore the project is profitable. Though the investment seemed to be viable, it required an additional $7.5 million which would have made the investment not viable since it could have given a present value of $-602435.2725. To raise this funds, the company had to borrow money from outside which would have made the company to go deeper into the debt crisis. McGill made the right decision to postpone the expansion plans considering the increasing inflationary rate. The Federal Reserve’s action of increasing the supply of money in the economy would result in depreciation of the value of money which would have lead to inflation. Its action of tightening credit also stimulated the inflation since interest rate rose severely. The 2007 Investment Decision Thomas McGill’s decision to invest was unsuitable since the project gave a present value of $-602435.2725 if an amount of $20 million was to be invested in the project. Since the company had an already debt that was still existing, McGill could have concentrated on settling the debt rather than selling the 25 year bond. The company could not afford to pay its shareholders dividends adequately with the ever increasing debt. McGill’s Decisions Analyzed over the 1990 to 2007 Period The decisions made by McGill are not improving over time. He has made a number of bad decisions that have resulted in the financial crisis that SBC is currently going through. His decisions to seek for external financing rather than use the retained profits have lead to low share prices in the stock market. For example in the year 1995 he could have made a very serious mistake if he would have decided to repay the long term debt with commercial paper with an inflation expectation in the near future. McGill should have looked for ways to reduce the company’s operational costs so as to increase the retained profits which could have been used to offset the loans. The increased remunerations of top management was to be reduced also to cater for the needs of the shareholders which could have resulted in high prices in the stock market. Evaluation of McGill’s Performance and his Future in SBC McGill’s decisions concerning external financing have contributed to the recent low earnings of shareholders and low share prices in the stock market. Although the sales of the company are on an up-trend the revenues generated are mostly used to repay the loans which were taken owing to McGill’s decision making. The managers of SBC decided to increase their salaries and bonuses at the expense of the shareholders’ dividends and the past state of the economy. McGill could have let the terms of remuneration remain at their original state or even reduced the salaries and bonuses at the time of inflation. He saw it fit to look for external financing rather than reduce the cost of operation were necessary. Although his internal financial operations were excellent, his decisions concerning external financing had landed the company into the financial crisis. Works cited. Brigham, Eugene and Ehrhardt Michael. Financial Management Theory and Practice. Mason: South-Western Cengage Learning, 2010. Print. Werner, Sebastian.Short Selling Activities and Convertible Bond Arbitrage: Empirical Evidence from New York Stock Exchange. Heidelberg: Gabler Verlag, 2010. Print. Solow Robert, and Taylor John. Inflation, Unemployment and Monetary Policy. Massachusetts: MIT Press, 1999. Print. Read More