Financial Management

Prepared for

Prof Dr. Jahangir Alam

Course Instructor

Prepared by

Jahin Masnun Md Nasullah Shibli Md. Faiz Fahad Bin Sultan BBA 15th Batch

Roll: ZR 07 Roll: ZR 13 Roll: ZR 14 Roll: ZR 24

Afroz Hossain Arefin Roll: ZR 33

September 11, 2008

Institute of Business Administration University of Dhaka

APT, Inc

Recommended option: Debt with warrants

Issues that are to be considered before deciding the appropriate financing option: 1. Apt, Inc needs $8 million now and $4 million in four years 2. Stock is depressed but should rise in a year to 18 months. 3. The company has virtually no debt remaining except short-term obligation.

Reasons behind not recommending the equity securities:

The stock price is depressed. If the firm wants to sell common stocks, people wont buy them. The firm will also not be able to price the stock high. Furthermore, selling common stocks will not secure the $4 million cash required in the future. So common stock is not a good option. Preferred stock will also fail to provide the future cash requirement even if the profitability of the firm rises. Since preferred stockholders are given higher dividends, they will also not be interested to convert the stock into common. The current stock price may discourage the investors of preferred stock too.

Reasons

behind

not

recommending

the

convertible

bond

or

callable

debentures:

Convertible bond allows the bondholder to convert the bond into common stock at a stated price. They can convert it into common stock at any time within a stated period. So, if the stock price rises, bondholders will want to convert the bond immediately. Then, it will be riskier for the firm to retire these debts as it has recently retired $7 million in debt. And this will hamper the firms additional fund raising of $4 million. So, convertible bond is not recommendable for Apt, Inc. This also fails to provide the future cash requirement. If the company calls the bonds, it will increase cash deficiency as the company will have to pay higher price for retiring the bonds prior to maturity. So it cant be a source of financing for APT, Inc.

Reasons behind recommending debt with warrants:

This firm has no long term obligation. Stock price is depressed but should rise within one and half year. It expects substantial increase in profit due to new machinery. The firm needs $8 million now and $4 million in four years. Debt with warranty will help the firm to collect money for current purpose and will provide future funds at time of converting those bonds into common stock at a predetermined rate in the long term. Bondholders will be interested in converting those bonds since the common stock price will rise and profit will increase substantially. Therefore this firm should issue debt with warrant.

Medford Enterprises

Recommended option: Callable bonds

Issues that are to be considered before deciding the appropriate financing option: 1. The company needs $15 million to finance machinery for plumbing supplies 2. Stock price is depressed, but it is expected to improve. 3. Excellent growth and profit are forecasted in the next year.

Reasons behind not recommending the equity securities:

Management of Medford Enterprises is not interested in surrendering voting control to outsiders. As selling of common stocks brings new investor into the firm and reduces the voting control of the existing shareholders, the management cannot go for issuing common stock. The stock price of this company is depressed. Though it is expected to improve, company will not issue stocks until the market becomes favorable to them. Again, this firm has a practice of retaining bulk of earnings and it pays low dividends. This practice of the firm will discourage the potential investors to buy shares of this company. After considering the above circumstances, if the company still persists on issuing preferred stock, it will risk of surrendering voting control. Because, according to the convertible feature of the preferred stock, preferred stock can be converted into common stock at the option of the shareholders. This will give a shareholder voting right. So, issuing preferred or common stock is not a good option for Medford Enterprises.

Reasons behind not recommending the convertible bond or debt with warrants:

Because of the above reasons, Medford Enterprises cannot go for issuing debt with warrants as this will allow the bondholder to buy shares of the company in the future at a stated time at a given price. It will not also be preferable to the crusty management of the firm. There are some disadvantages also if the firm issues convertible bond. As the convertible bonds can be converted into common stock at a stated price at the option of the

bondholder, the bondholder can get the voting right in the long run. Again, the stock price is depressed currently and the firm offers low dividends. So the potential buyers of convertible bonds will be discouraged by the above situation to invest in this type of security. So, it will be a very tough for Medford Enterprises to raise $15 million.

Reasons behind recommending the callable debentures:

If the firm goes for issuing callable debenture, it will have an upper hand to raise the $15 million. Callable bonds allow a corporation to retire the issue at a fixed price prior to maturity. Medford Enterprises has a low debt-equity ratio as this firm has a record of retire a debt prior to maturity. So, features of callable bonds go with the practice of the firm. Though the call price is normally higher than the face value, Medford Enterprises can afford the value as the firm has an excellent growth and profit forecast in the next year. Issuing this type bond will not cost the company to surrender voting control to outsiders. Bondholders have an option to convert the bond into common stock during the period between call rate and retirement rate. But it will not be necessary as the call price is normally much higher than the price of conversion of the bond. Bondholders will also be encouraged to retire the bond rather than conversion because of the low dividend payment rate of the firm. So, by analyzing the pros and cons of different securities, it is recommended that Medford Enterprises should go for issuing callable debenture to collect $15 million to finance machinery for plumbing supplies.

Woltersdorf Brothers Inc.

Recommended option: Common stock

Issues that are to be considered before deciding the appropriate financing option:

1. The firm needs $25 million to expand its cabinet and woodworking business. 2. The firm cannot raise more than $10 million with straight debt. 3. The firm seeks additional shareholders.

Reasons behind not recommending the debt securities:

The firm cannot raise more than $10 million with straight debt. So the firm can not issue any type of bond as if the firm decides to do so it will have a shortfall of $15 million which is a substantial amount.

If the firm decides to issue debt with warrants, bondholders will be able to buy shares of the company in the future during a stated time period at a given price. However, to raise the $15 million by issuing bond with warrants the firm will have to wait for a long period. But it is not a suitable option for the firm to raise $10 million now and wait for a long period to get the rest $15 million as the firm is considering expanding its business now. So issuing bond with warrants is not a viable option for the firm.

From the definition of convertible bond we know that convertible bond can be converted into common stock at a stated price at the option of the shareholder. Conversion price is usually higher than the issue price. If the firm decides to issue convertible bond the firm has to wait to see if the shareholders are willing to pay 2.5 times higher amount of money for the shares. So issuing convertible bond is not an option for the firm.

Callable bond allows the corporation to retire the issue at a fixed price prior to maturity. The call price to retire the issue is usually higher than the par value. So if the firm decides to retire the issue then it has to spend money from its own fund to cover the higher amount of call price than the par value of bond.

So even if after considering all this factors, the firm decides to raise $10 million by issuing bonds the firm either has to issue common stock or preferred stock to raise the rest $15 million of the total $25 million. However, the firm cannot issue a bond and a stock at the same time as it can issue only one type of security to raise the needed amount of money for expansion work. So issuing debt security to raise the needed capital is not a viable option for the firm. It leaves the firm only with two options- it can either issue common stock or issue preferred stock.

Reasons behind not recommending the preferred stocks:

If the firm issues preferred stock, it will have to pay dividends to the preferred stockholders at a fixed and specified rate even if the firm faces loss. If it fails to pay dividends in any year, unpaid dividends will be carried forward to the next year. Usually, a firm issues less preferred stock to avoid such obligation. As the firm needs $25 million, it will not be a good decision for the firm to issue preferred stock to raise this huge amount of money.

Reasons behind recommending the common stock:

The firm seeks additional shareholders. It has a fair management with very good growth prospects. As the firm has very good earnings it should spark investor interest if it decides to raise money by issuing common stock. The management which seeks additional shareholder can use its growth prospect to attract investors as the firm should be able to declare handsome amount of dividend. Even if the firm fails to pay dividends in a year it will not have to pay the unpaid dividends in the next year. And as the firm has no reservation about surrendering voting control to outsider, common stock is the best solution for the firms need.

Massachusetts Energy Systems

Recommended option: Convertible bond

Issues that are to be considered before deciding the appropriate financing option:

1. the firm is well respected by the liberal investing community near the boston area 2. The current share price in market is $15 and the company wants to sell the shares at $20. 3. The company needs to raise fund of $25 million.

Reasons behind not recommending the equity securities:

The market price of common stock is $15 per share and the company wants to sell at $20 or more per share. Common stock will not be a good option for the company since the market price is lower than the price at which the company is willing to sell.

The reason behind not choosing preferred stock is its cumulative feature. It says that any unpaid dividend will be carried forward to the next year by the company. It is a burden because in this case the company must pay the dividend to the stockholders no matter what happens. So it certainly stands in the way of the companys fund raising project.

Reasons behind not recommending the debt with warrants or callable debenture:

Debt with warrant actually allows the bondholders to buy shares of that particular company in the future during the stated time period at a given price. In this case, when the bondholders buy the shares, the company has to give the interest of the common stock as well as the interest of the bonds. Company will not do it as it is intended to raise fund. Another point is that the company has to make offers to the bondholders to allow them buying shares. Company has to observe market condition and other factors which affect the share price. It is time consuming. So debt with warrant is not a good option.

Callable debentures allow the corporation to retire the issue at a fixed price prior to maturity. Call price is usually higher than the par value. So even though it has options for the bondholders to convert this bond into common stock, the company can not go for it because of higher call price. It will mean a total loss for the corporation and it could not be able to raise its $25 million.

Reasons behind recommending the convertible bond:

Considering all other options above it is clear that convertible bond is the only option that can be adopted. There are a number of reasons behind choosing convertible bond. First, the company cannot sell common stock at $20 or more per share because the market price is $15 per share. So the company cannot go for selling common stock though it was their first choice. Second, it is a sound growth company. So there is a good possibility that the share price will increase in near future. Now if the company issues convertible bond, there is an option always open for the bondholders to convert the bonds into common stock when the share price is up. At that time bondholders will obviously convert the bonds into common stock for better profit. We know that the conversion price of this type of bond is higher than the issued price. So the company will make profit gaining the extra money from the conversion price. And thus will raise the $25 million.

Pagano Industries

Recommended option: Preferred stock

Issues that are to be considered before deciding the appropriate financing option: 1. The company cannot issue debt without permission of bondholders and First National Bank of Philadelphia. 2. The firm is in need of long-term money. 3. Management is reluctant to surrender control.

Reasons behind not recommending any debt securities: As the company is willing to collect a large amount for a long-term basis, it can either issue equity security or any debt security. But issuing debt security also creates a liability of permitting a fixed interest rate per year which they have to continue till the maturity period. The problem can easily be overcome by the company as they seem to have a low equity debt ratio. But there are other factors as well. In the case of convertible bond, the stockholders can convert the bond into common stocks and they can buy common stocks at a stated price. Thus they become owners of the company who has control over the company. But management is reluctant to surrender control. So it is unlikely that the firm will go for convertible bond. If Pagano Industries issue debt with warrants, they will have to surrender control when the bondholders will buy common stock at a stated price within a stated period. Same goes for callable bond as stockholders can convert the bond into common stock during the period between the call date and the retirement date. Besides, the company is facing complexity in issuing debt security as they have to seek permission from the bondholders and First National Bank of Philadelphia at the same time.

Reasons behind not recommending the common stock:

Pagano Industries will happily accept a solution that allows them to avoid fixed interest. In this case, they would appreciate equity security. But issuing common stock would also introduce new stockholders along with voting rights which somewhat reduces the overall control of the existing shareholders over the company.

Reasons behind recommending the preferred stock:

Thus, preferred stock is the best solution for Pagano Industries. It allows the company to overcome all the three issues as 1. It fulfills the need for long-term money. 2. No more need to seek permission from the bank. 3. Preferred stockholders have only limited voting rights. And most of all, preferred stocks have call features. Pagano Industries earns relatively high profit. So, at the beginning they may need to offer certain amount of fixed interest, they can avail $20 million very fast and can use the call feature to retire the excess stocks if needed. In this way, preferred stock perfectly solves all their needs.

Bibliography: Books: 1. Fundamentals of Corporate Finance, sixth edition By: Ross, Westerfield and Jordan 2. Foundations of Financial Management, eighth edition By: Block and Hirt

Websites: 1. www.aarp.org/money/financial_planning/sessionsix/bonds.html 2. www.investopedia.com/terms/b/bond.asp 3. en.wikipedia.org/wiki/Bond_(finance) 4. http://www.finweb.com/investing/types-of-bonds.html