Way of Providing Capital from the Perspective of PP Inc and Those Who Provide the Capital - Assignment Example

a) Advise Sara on the different ways that her friends and family can provide her the capital they promised. Explain the consequences of each way of providing capital, both from the perspective of PP Inc and its shareholders and those who provide the capital. What do you recommend in light of her circumstances? (20 points) It is a universal truth that any person on earth who makes an investment does so to get a return from business. There are two types of investment either through debt or through equity. Any person can invest in Equity or Debt according to his or her requirement and intention to invest and depends on different criterion. Financing can also be analyzed as per different time aspect. In case of equity investment the effect is of having ownership in the respective company. It is usually the prime and main source of fund and forms the foundation on which the business exists. It paves way for the future borrowing of funds which may be required for the smooth running of the business. The respective corporate laws govern the rights and responsibilities of Equity holders. In case of Equity share holders the rights of the share holders are limited to their control of the management by exercising the voting rights by shareholders usually equal right is exercised by each shareholder one share one vote. Otherwise equity shareholders do not get any automatic right on profit share; in fact they are the last ones to get the share of the profit usually this is done through dividend payment or bonus shares. As their right on the profit of the company is last after paying off the other debtors so they bear a great amount of risk on their investment and are exposed to high risk of total loss on the investment. The specific rights exercised by equity shareholders are as follows; The right to amend the articles of incorporation Adopt and amend by laws Elect the Directors of the Board of the respective Corporation Power to authorize the sale of fixed asset of the corporation Initiate merger and acquisition of the Corporation Alter the number of authorized share capital both common and preferred Power to alter the rights and restrictions on the common shareholders Power to change the rights of preference shareholders or others into common shares So incase common shares are issued to raise capital then the control of the management will be diluted as the majority shareholding pattern will change and as specified above the powers exercised by the holders of the newly issued common shares may take away the controlling power of Sara and her thereby exposing the Corporation into hostile takeovers or change of management. Other than the above characteristics the holders of common share have the following special rights like: Right to exercise voting power Right to sell respective shares except under special circumstances On liquidation they have right to the residual assets of the corporation They have the right to inspect the accounts and other statutory corporate books Right to appraisal Dividend payout right Other preemptive rights There may be different types and class of common shares which have different voting rights and other privileges, common shares with no voting rights have higher dividend yield but are traded at lower value in the market. There are some advantages for the corporation to issue common shares these are the corporation is under no obligation to pay any fixed payments, there is no redemption date and it may be infinite, the value of common shares increases the borrowing capacity of the corporation as ideal debt equity ratio is 2:1, can be sold at well above market value depending on the sound financial position of the corporation, money can be borrowed against security of such shares. Some major disadvantages are that the shares inherit voting rights i.e. virtual control over the company. It circumscribes a right on share of profit; the cost of selling common share is much higher, shares issued in IPO’s are usually undervalued with respect to market price, when declared dividends are not deductible. Preference shares are characterized by the fixed return or dividend at fixed rate if declared as per section 42 CBCA. The holders of preference shares get preference for their claim for interest and dividend over common shareholders. It has similarity to bond and can be taken as equity or debt on the basis of analysis. Preference share may have different class and dividend. After wind up they have power to the remaining assets of company. There are different classes and series of preference shares some have participatory rights on wind up; it also includes rights of redemption or repurchase by the company. As stated earlier, preference shares have conversion right attached and it does not include any additional fund. Every company is required to repurchase a certain ratio of preference shares issued by it every year for redemption. Preference shareholders do not have voting rights except when their dividend is not paid, when the rights of the shareholders are affected by the company decision and when there is a major change in the company. Preference shareholders have a right to proportional interest on the company by investing on pro rata basis in the future issues of the company. It is further safeguarded that the company cannot in future issue shares that have over riding rights attached to them than the existing preference shares like right to dividend or voting etc. Preference shares may have quality ratings just like bonds e.g. DBRS etc. The main advantages of preference shares are they are almost like debt without obligation for fixed interest payment; it can be used to enhance financial equations without stretching the solvency of the company, it is almost like equity shares without the characteristics like right of voting etc, capital can be raised without any mortgage on assets which can be used in future. The main disadvantages being that dividends though not mandatory is expected to be paid and have preference over other shares, some important strategic decisions needs approval of preference shareholders also, fixed dividend rates may be a burden for new companies, taxation may vary as per norms. There is some non share equity like trust units and partnership units that can be used to raise capital without issuance of share but other obligations may remain same. Another type of capital rising can be done through debt financing; this will include either capital raised through public debt or through private debt, before raising debt it is important to have authorization of the company to do so. There are mainly three categories of debt: 1) Short Term 2) Medium Term 3) Long Term Short term is usually for a period of 1 year, here the interest is cheaper than long term debt but can be high risk proposition as per the company some examples are accrued wages, trade credit, inventory financing, advances from shareholders etc. Medium term loan is usually for 5 to 7 years like medium term promissory notes and other notes etc. and bank loans. Long Term debts are usually for more than 7 years and the lenders will check strict criteria to avail it, usually these debts are cheapest and examples are mortgage, bonds and debentures, such debts may be against mortgage of assets like real estate, land building etc. the borrower still has to show its financial credentials like the debt equity ratio etc. long term debts through bonds have trustees to govern trust security and act as intermediary between company and the bondholder. Long term unsecured debentures are also governed by a trust and their function is similar to above. There are long term debt covenants and its duty is to protect debt holders while allowing normal business of the company. It puts several restrictions like, restriction on creating secured debts, proof of enough working capital, restriction on disposal of assets etc. Another important loan is syndicate loan where banks form syndicate to finance large scale loans ranging from millions and billion dollars. Large corporations or governments can raise capital by issuing international bonds through Foreign Bonds and Euro Bonds. The main advantages of debt financing is that there is no issuance of new shares which means the management remains unchallenged, the fund is economic and rate of interest is low, payback on maturity and limited cost to company. Equity shares improve debt equity ratio of the company, there is no obligatory fixed interest payout to shareholders, and the prestige of a company gets enhanced because of stock exchange listing. In case of debt there is obligation for fixed payment irrespective of loss making, it is restricted to the maximum amount of des to be raised. Raising capital through Equity shares may dilute the control and management of the company and the dividends issued may be more expensive. Other form of capitalization is called Hybrid securitization it includes: Options Warrants Rights Convertible Securities Hybrid securities are means by which companies find alternatives to attract investors. Options are not exactly a source of raising capital e.g. being employee’s stock option etc. Warrants are there which form long term call option and can be traded separately. Though it can raise capital but it may weaken the controlling interest of incumbent shareholders. Rights shares are issued to present shareholders; it does not need any prospectus and does not need any underwriter’s commission payment, it can raise capital with out hostile take over. Convertible securities are also used to raise capital but the company needs additional funds at the time of conversion. But it may not be that useful to deliver perfect results. Sweeteners are another form of security that is enclosed with security features that look more lucrative. In this case as Sara ants to keep control over the company together with uncle Bob Bongars and friend Ami Longtemps so it is unlikely they can afford any issue of Equity Shares as that will dilute their control over the shareholding and also the company. Again preference shares can be issued but that will be an additional obligation of fixed interest rates and redemption after a while. Again in this situation it is justifiable for the Sara to raise capital by getting long term loan, as the interest will be much lower and she will have the control, but it will be difficult as it is a new company without any background, so she may issue 10000 preference shares and since the debt equity ratio should be 2:1 so he company can borrow some capital either through unsecured Debentures or Loan so $60000 can be raised this will total to $100000, which is the required amount Quaid (2010). (b) Sara is discouraged but she does not want to give up yet. After consulting with Bob and Ami, they all agree that there is no choice but for PP Inc to approach an arm’s length sources of funds. They are apprehensive about what is involved. Advise Sara, Bob and Ami as to what types of information potential investors will expect from PP Inc before providing any capital. (5 points) PP Inc in order to in order to source funds from market must issue a prospectus or a statement in lieu of prospectus which will contain the following information about the Corporation, the offer including amount, price, minimum purchase, rationale, objectives of investment, reference to the portfolio, quarterly distributions of profits, ratings, redemption option if any, buy back from market, manager, mortgage broker if any, sub administrator, eligibility for investment, Income Tax provisions, risk factors, summary fees and expenses etc Quaid (2010). (c) CO is willing to be a passive investor in the business and leave the scientific and strategic decisions to management and the board. However they want the ability to increase their investment if things go well. Sara, Bob and Ami are uneasy about this. They ask you to explain how this could be done what the consequences would be for PP Inc. Explain all possible approaches for structuring Confederation Oil’s passive investment. (20 points) In this case it is clear that Confederation Oil wants to be involved in the company only as a passive investor i.e. it will not be involved in the company as a shareholder as stated earlier in case of equity investment the effect is of having ownership in the respective company. It is usually the prime and main source of fund and forms the foundation on which the business exists. It paves way for the future borrowing of funds which may be required for the smooth running of the business. The respective corporate laws govern the rights and responsibilities of Equity holders. In case of Equity share holders the rights of the share holders are limited to their control of the management by exercising the voting rights by shareholders usually equal right is exercised by each shareholder one share one vote. Otherwise equity shareholders do not get any automatic right on profit share; in fact they are the last ones to get the share of the profit usually this is done through dividend payment or bonus shares. As their right on the profit of the company is last after paying off the other debtors so they bear a great amount of risk on their investment and are exposed to high risk of total loss on the investment. It can take other means of investing in the company in Preference shares. The holders of preference shares get preference for their claim for interest and dividend over common shareholders. It has similarity to bond and can be taken as equity or debt on the basis of analysis. There are different classes and series of preference shares and includes rights of redemption or repurchase by the company. As stated earlier, preference shares have conversion right attached and it does not include any additional fund. Every company is required to repurchase a certain ratio of preference shares issued by it every year for redemption. Preference shareholders do not have voting rights except when their dividend is not paid, when the rights of the shareholders are affected by the company decision and when there is a major change in the company. The main advantages of preference shares are they are almost like debt without obligation for fixed interest payment; it can be used to enhance financial equations without stretching the solvency of the company, it is almost like equity shares without the characteristics like right of voting etc, capital can be raised without any mortgage on assets which can be used in future. The main disadvantages being that dividends though not mandatory are expected to be paid and have preference over other shares. They are mostly passive in the sense they don’t have to be actively involved in the management of the company. Another alternative may be through debt financing with option of convertibility in future including debentures, securities, bonds etc. PP Inc will be free as per as its management is concerned to take strategic decisions and also it’s requirement for working capital is met. Only problem may be that because of lack of interest on the day to day functioning CO may not extend any strategic consultation and may only be interested in returns as returns are risky for this new venture in future it may be a obstacle for the investor. Other than these CO can opt for investing through friendly mergers where it will not affect the management of the company but act as an investor only. As CO is financially powerful and it has an intention of increasing its investment in future so if the scientific experiments are successful and the projects succeeds then there is possibility of hostile take over by CO, Quaid (2010). (d) Sara, Bob and Ami are intrigued by this expression of interest from GES Inc and want to know more. Explain to Sara, Bob and Ami the different methods by which PP Inc and GES Inc might be combined. Be sure to outline for them the advantages and disadvantages of each method. What method do you recommend them to pursue with GES Inc? (10 points) GES Inc and PP Inc if combined together that will amount to corporate restructuring. Strictly speaking corporate restructuring is not a form of capital rising but it involves the following types, by selling of all the shares or assets of the company, merging together of companies, taking over the management of the company, amalgamating two or more companies, arrangement between companies, divestment of companies, de merger of companies and reorganization of companies. Mergers may be horizontal, vertical, analogous or conglomerate. In acquisition the company targets an acquiring company and either opts for friendly takeovers where both the management groups work closely or hostile takeovers where shares are purchased from market or other shareholders and majority stake its claim on the management. An acquisition can be completed by acquiring the assets or shares, by amalgamating with another company, arranging with another company. The main reason for merger may be economic, financial and tax saving. After merger what are the terms of control. It is important to note the impact of the takeover bid on the company, a take over bid may be initiated by giving written intimation or by buying shares from stock exchange, rules regarding takeovers like security law as well as corporate law requirement shall be kept in mind. Take over bid may be general or indirect other type includes by issuing shares or initiating from within the company. The takeover bid can be accepted, reject or form a special committee to judge its viability. Other takeovers may be by leverage buyouts where the financial and other points are considered. Companies may convert itself as a private holding by acquiring all outstanding common shares with special provision for minority shareholding. There are few other procedures where companies agree to work in close association with out actually merging with forming joint ventures, strategic or marketing deals. Another form is by divestment where companies sale or dispose off assets, other types are de mergers etc. Since here the combination is for mutual benefit so both the companies can form a strategic partnership where they can assist each other with their strong areas and do some joint research to successfully implement their project objectives and as it can be seen that GEC Inc is a local biotech company so they can work together strategically to achieve their respective goals, Quaid (2010). (e) Assuming that PP Inc is not in default of any of its obligations under the loan agreement, explain to Uncle Bob, Sara and Ami how this clause affects the deal with GES, Inc. Can the deal still go forward? (5 points) As per the clause given in the loan agreement by the bank if there is any amalgamation, merger, consolidation etc the entity of the company as a corporation must exist i.e. it should not become a non registered entity and the registration should be in as per law of incorporation of Canada or a province of Canada. The new formation must execute a separate agreement stating the rights and obligation under the loan agreement shall be respected by the new entity. The deal can be pushed forward by adhering to above conditions, Quaid (2010). (f) Explain to Sara the differences between a publicly held company and a privately held company. Identify any particular things that Sara should be aware of as a potential member of the management team of GES, Inc. (5 points) A public company has shares which can be offered to the public, private companies shares are closely held and cannot be traded in public, public companies can be incorporated with minimum 2 members whereas public companies must have at least 7 members, private cannot list their shares in stock exchange for trading which public company can. Public company can raise capital by issuing prospectus from public, private company cannot. In a public company the director’s liability is limited while in private company it is unlimited. Public company is a separate entity from its share holders but in private companies shareholders are held responsible by the doctrine of Piercing the Veil. Public companies can issue share warrents while private company cannot. Sarah should be aware of the financial aspect of the company as well as its shareholding patters whether it is closely held or an ordinary public company, Quaid (2010). (g) Explain to Sara what an option is and why GES has offered options to her in connection with her employment. (5 points). An option is employee’s stock option where employees are given some specific number of shares every time specified as their stock option which is the procedure of involving the employee to the company by giving him a share in the ownership of the company. Usually such shares are issued at a much cheaper value than the market and carry a prohibitory clause of non disposal except after a specific time frame. It is a management policy where the employee is given an opportunity to become a shareholder of the company and also part in the profit that comes from the result of their hard work, Quaid (2010). (h) Based on the information above and the financial statement of GES, Inc. (see pages 7-9), give Sara both an assessment of the Company from an equity holder’s perspective and an indication of how valuable the options offered to her might be now and in the future. Support your analysis with appropriate financial calculations (20 points). In order to get a clear idea and when assessing a company or a transaction, comparisons must be made between financial data, as how to compare companies when they use different sets of accounting standards. Valuation and interpretation of financials is not done in the for specific purpose and a definite goal is set, purpose of the financial analysis is to assess the operational point of the company, evaluate the working of its management, the performance graph, how well and efficiently it can utilize its funds etc. Some important aspects of financial analysis are ROE i.e. return on equity, it depends on net margin, asset turnover and financial leverage. Valuation of a company is a complicated process and it is the agreed price of a company by the buyer and seller. Some important ratio that are calculated are, Efficiency ratios like, Gross profit, operating leverage etc. Valuation Ratios like earning per share, Price earning, dividend yield, capitalization ratios, and debt leverage ratios like debt equity etc. liquidity ratios like working capital ratio, quick ratio and lastly productivity ratio. Total Debt outstanding is $194000 Invested Capital is $ 234000 The net profit margin is Net Income / Sales = 11.6% which is very low compared to other corporate. Asset turnover ratio which is Sales / Total Asset = 43.8% In order to calculate Return on Equity the following steps are required e.g. Return on Asset 14000/274000*100 = 5.1% Then it is required to calculate Financial Leverage Total Asset / Shareholders Equity i.e. 274/40 = 6.85 Net Income / Shareholders Equity = 14000 / 40000 * 100 = 35% Alternatively Return on Equity = 5.1* 6.85 = 34.94% Here we can see that the return on asset is quite low and financial leverage is as high as 6.85 which together are giving a low return on equity of 34.9% only so the use of asset to create profit is not efficient and it needs more strategic planning in this front. The profitability ratios are calculated below it will throw some light on the efficiency of converting sales to profit. Operating Profit Margin 120000-75000/120000 = 37.5% It shows the percentage of sales which is available to adjust non-operating expenses here it is 37.5%. Net Profit Margin is the measure of profitability and the efficiency by which profit is made. Net Income / Sales = 14000/120000 = 11.7% it is very less and needs improvement. Earning per common share is 2.80 on basic Price/Earning per Share = 5/2.8 = $1.8 per share which is healthy. Net Return on Common Equity= Net Income/Shareholders Equity= 14000/ 32500 = 43.08% is quite healthy and worth investing. Debt Equity ratio it is calculated to find the company’s debt situation that whether it is heavily borrowing. 194000/40000 = 4.85 the ideal debt situation is 2:1 here it is very high it means that the company will pay heavy interest for servicing its debts and future it may be in difficult situation. Working capital ratio depicts the overall liquidity position of the company. 192000/274000 = $0.7 for every $1 it is reasonable Current Ratio shows the adequacy to meet short term obligation i.e. Current Asset/ Current Liabilities = 192000/49000 = 3.92 here it is very good and can meet any short term obligation. Quick Ratio which shows the flow of inventory and 1:1 is considered excellent Current Assets- Inventories/ Current Liabilities = 192000-100000/49000 = 1.8 which is a bit high but can be kept under control. Receivable turnover is used to calculate revenue by extending credit to trade creditors i.e. Sales/ Receivables = 120/14 = 8.57 Average collection period = 365/ Receivables turnover = 365/8.57 = 42 days Inventory turnover ratio is cost of goods sold/inventory = 55000/100000 = 0.55, Quaid (2010). Question II (10 points) In preparing your answer to Question II, assume the only relevant and applicable law is the Supreme Court of Canada decision in BCE. Advise the Board. Can it proceed with the transaction? Explain why or why not. The above case is similar to the judgment passed in the case of BCE Inc. v. 1976 Debenture holders. Here it was alleged by some debenture holders that they are being oppressed under Canada Business Corporations Act, R.S.C. 1985 c. C-44, ss. 122(1) (a), 241. Proposed plan of arrangement not arranging rights of security holders but affecting their economic interests and whether plan of arrangement was fair and reasonable. It was found that the offer to purchase was at the best of interest as in this case also and the Quebec superior court set aside the contention of Debenture holders but court of appeal found out that it is not fair and should not be approved by the Board and that requirement of Section 192 needs to be met. Bell Canada and BCE appealed against this order and held that Section 241 oppression remedy and Section 192 are different and needs differential treatment. Section 241 oppression remedy is available only for substantial oppression which is just and equitable for substantial number of debenture holders and is fact specific and is reasonable expected. Claimant must show reasonable expectation was not met and it was prejudicial and unjust. The interest of debenture holders was safe guarded and leveraged buyouts are not unusual or unforeseeable, and the debenture holders could have negotiated protections in their contracts as they were getting reasonable price for their investment. Otherwise the market condition was such that it needed for its plan of expansion such arrangement. Under Section 192 approval process is fair and affected individuals right is properly met with and statutory provisions were met and the proposal is just and reasonable. It is further shown that it was a proposal and fair reasonable test was done and approved by a vast majority of share holders. The trial judge stated that 98% opinion cannot be allowed to veto simply because the trading value of their securities would be affected. Also the debenture holder’s interest is fairly and reasonably met. So like above the similar case of merger with Swivel will be accepted provided the measure is just and reasonable and in right of the above case history. So the deal can be accepted and preceded successfully, Consumer and CorporateAffairs Canada, (1977). Bibliography BCE Inc. v. 1976 Debenture holders, 2008 SCC 69 Canada. Consumer and Corporate Affairs Canada. Detailed background paper for an Act to amend the Canada Business Corporations Act. Ottawa: Consumer and CorporateAffairs Canada, 1977. Jennifer Quaid 2010 Corporate Finance for Lawyers 27 Jan – 2 Feb Sparling v. Quebec (Caisse de dépôt et placement du Québec), [1988] 2 S.C.R. 1015 Read More