Case Analysis

PREFERRED STOCK ISSUANCEBRUKVEILL-DEBT-VS-EQUITY

Group 2
Ambokar Nimish | Anurag Gupta | Ashwin Mathew Philipose | Avinash Murali
Nair |
B Ushashree | Baidyanath Bose | Balakrishnan M

The Organization

Electricity utility company providing electricity to industry and consumers

Serves majorly n areas of rural community concentrating the border areas of

two adjoining states in the Midwest

Morgan and Bill Frederick, the corporate controller managed the companys
financial staff

Company was financial sound and agile

Forecasted with good growth opportunities

Issues at hand

Debate over long-term funds revolved around the type of security (Common
stock, preferred stock and debt) to use in the acquisition of the funds

Funds required for an overdue replacement of several of its substations and

several other expansion and replacement projects

Several aspects of preferred stocks to be considered for financing

Determine whether preferred stock issuance was in the best interest of BPL
and its customers

Question1:
Calculate the ROE and total debt/total assets ratios for BPL for 1992.

Solution:-

ROE of the company = Net Margin/Total Equity

= 3881/33859 =

11.46%

Total Debt to Asset Ratio = Total Debt/Total Asset

= (8713 + 75623)/120180 =

70.17%

Question 2:
What is the feasibility of debt or common stock issuance for BPL?
Solution:

Feasibility of a Debt
DEBT TO ASSET RATIO
Industry Debt to asset ratio

24%

Company Debt to asset ratio

70.17%

Company D/A ratio > Industry D/A ratio consequently the company is more riskier.
so, it should not go for more debt.

Cost of Debt will be high for the company, interest rate on corporate bonds are high

Conti.

Feasibility of a Common Stock Issuance

Industry ROE = 11%, Company ROE = 11.14 %

ROE of the company and the industry are almost same, which signifies that if
company goes for issuing more common stock then it may lead to lower ROE, which
in turn lead to lower EPS

Market for common stock was in a depressed state

Dilute the ownership and control of the existing shareholders

Common stock dividends are not tax deductible payments

Question3:
If long-term funds must be acquired at this time, is preferred stock a feasible alternative?
If the $50 preferred stock of the similar utility is a perpetuity, and BPLs issue will also be a
perpetuity, what is the yield on each issue of stock?
Solution:-

Preferred stock dividends are paid at the discretion of the company, so preferred stock
dividends could be deferred in times of financial distress

Longer-term maturities with fixed yields provide a hedge against deflationary environments

Company has already loaded their balance sheet with a large amount of debt and risk a
downgrade if they piled on more

Preferred dividends are not tax-deductible

In case of falling rate environment, company can benefit from call option of converting
preferred stock to common equity

Yield of the preferred stock:- Annual Dividend per share/ Price per share of preferred
stock = 6/100 = 6%

Question4:
Is preferred stock a fund-raising mechanism used only by utilities?
Solutions :

Bank holding companies treats certain types of preferred stocks (what are
called hybrid preferred stocks) as Tier 1 capital (a key measure of a bank's
financial strength) for capital adequacy purposes

In addition to utility, any companies with weaker credit ratings can issue
preferred stock irrespective of the industry

Question5:
List some important characteristics of preferred stock. Why are these characteristics
important? If the BPL issue is cumulative, what are the implications for voting rights of
the preferred stock holders?
Solution:

Characteristics of Preference Stock

Participating Preference Shares - Participating preference shareholder receives

stipulated dividend and shares additional earnings with the common shareholders.
But this share is usually non-cumulative

Cumulative Preference Share - Cumulative provisions accumulates if dividend not

paid by the company. Normally, the firm must pay these unpaid dividends prior to the
payment of dividends on the common stock.

Non-Cumulative Preference Share Cumulative provision do not accumulates in

case of default by the company

Voting Rights - Preference shares do not normally confer voting rights except in
certain special circumstances which will discussed in coming slides

Conti.
Par Value-

No-par value stock is issued by the company without specifying the par value
in the prospectus

Most preference shares have a par value. When it does, the dividend rights and
call price are usually stated in terms of the par value. However, those rights would
be specified even if there were no par value

Redeemable or Callable Preference Shares

Non-callable preference shares and bonds are issued in periods of high interest
rates

Preference shares have no maturity date

Redeemable or callable preference shares may be retired by the issuing

company upon the payment of a definite price stated in the investment. call
price provides for the payment of a premium, the provision is more advantageous
to the corporation than to the investor

Conti.
Sinking Fund Retirement-

Preference share issue is often retired through sinking funds. In these cases, a
certain percentage of earnings (above minimum amounts) are allocated for
redemption each year

Sinking Fund have favourable overtones for the owners of shares as dividend
payment become more certain

Preemptive Right-

Depending on Common law statute , preference shareholders gets the right to

subscribe to additional issues to maintain their proportionate share of ownership

Conti.

Implications for voting rights of the preferred stock holders if the BPL issue is
cumulative

The cumulative preference shares can vote if their dividend is in arrears for 2
years. The voting right of each preference shareholder is to be in the proportion
which the paid-up share capital on his shares bears to the total equity share
capital of the company.

In India, for instance, the non- cumulative type qualifies for voting rights if
preference dividends have been in arrears for the two financial years preceding
the meeting or for any three years during a period of six years (ending with the
financial year) preceding the meeting.

Question6:
What is the long-term effect upon financial structure of a preferred issue convertible
to common stock? What is the purpose of the convertible feature?
Solutions:

Long Term Effect

When financial analysts, investors or corporate managers evaluate a companys performance,
they take potential dilution of EPS into account

Holders of convertible preferred stock can exchange their shares for a specified number of
newly minted common shares

Corporations can take various "anti-dilution" measures when issuing convertible securities to
lessen the probability or impact of dilution

Convertible preferred stock is dilutive since conversion increases the number of common shares,
thereby reducing the ownership level and EPS of each

Conti.

Why convertibles? Or the purpose of convertibles

With convertible preferred, a company can secure a lower interest rate than with
puredebt financingand use the promise of a dividend to sellsharesat a higher price
Issuing convertible preferred is a way for companies to raisecapitalon bettertermsthan
they could with traditionalequity financing, especially if they have lowstockprices
already (newequitywould dilute shareholders considerably) or if they have
poorcreditand cannot borrow at reasonable rates
Companies with poor credit sometimes use preferred shares togainrevenue, the risk
ofdefaultmay be slightly higher

Delayed dilution of common stock and earnings per share (EPS)

Different investors have different risk-return tradeoff preferences and issuing preference
share to appeal to the broadest possible market

Question7:
Comment upon the relative debt burden of BPL compared to the industry data given
in Table 4. Comment further upon the ability of utilities to carry fixed-income
obligations
Solution:

Relative Debt Burden of BPL compared to the industry

Industry Debt to asset ratio = 24%, Company Debt to asset ratio = 70.17%
Company D/A ratio > Industry D/A ratio implying that company is more
leveraged and riskier. So, it should not go for more debt

Ability of utilities to carry fixed-income obligations

Interest Coverage Ratio = EBIT/Interest Expense = 5900 / 4219 = 1.39

Ability to pay debt expense is questionable as ICR is very low

Curtailment of industrial demand will lead to less income in future, which in turn
would decrease ICR further

Question8:
Discuss alternatives to a preferred stock issue for the company
Solution:

Alternatives to a preferred stock issue for the company are debt financing and
common stock issue
Debt Financing

Interest rate on corporate bonds are high, so Cost of Debt will be high for the
company

Companys debt to total assets ratio was at a level beyond which the financial staff
believed a downgrading of the companys bond rating would be possible

ICR is very low so company should not go for debt financing

Conti.
Common stock issue

Process of raising capital through the sale of common share

ROE of the company and the industry are almost same, which signifies that if
company goes for issuing more common stock then it may lead to lower ROE,
which in turn lead to lower EPS.

Market for common stock was in a depressed state. As measured by the usual
indices, the market was at a two-year low

Dilute the ownership and control of the existing shareholders

Question9:
Discuss the feasibility of a long-term debt issuance convertible to common stock.
Solution:

Feasibility of a long-term debt issuance convertible to common stock

Lower fixed-rate borrowing costs- Convertible bonds allow issuers to issue debt at
a lower cost. Typically, a convertible bond at issue yields 1% to 3% less than
straight bonds. This would help in decreasing Interest Expense and maintaining ICR
which is favorable for the company.

Higher conversion price than a rights issue strike price Company can fix
conversion price for a convertible bond higher than the level that the share price
ever reached, which would help in the gaining higher premium

Voting dilution deferred- With a convertible bond, dilution of the voting rights of
existing shareholders only happens on eventual conversion of the bond

Question10:
What is the likelihood of a preferred stock issue being well-received by investors?
Solution:

From the shareholders' perspective preferred stock enjoys a higher claims to the
issuer's earnings and assets than common stock

Preferred stock dividends must be paid prior to common stock dividends

Preference shareholders may perceive it as the move is to avoid dilution of the

control for more efficient functioning of the company

On the other hand, investors may wonder why BPL would issue preferred stock
paying a generous dividend when they could presumably issue debt securities with
more favorable tax consequences

Investors may also not be confident of receiving regular dividend in the future due
to contraction in demand leading to lower earnings

Question11:
What is the role of the financial intermediary in BPLs capital needs situation?
Solution:Financial Intermediary help BPL in arranging financing through following options
available to them:

Private Equity - Private equity are the firms that provide funding to companies
that are mature in their life cycle and BPL is one of them

Loan Syndication- It is kind of debt financing where banks can arrange funds from
a group of banks called syndicate and this process is called loan syndication

Issue Management- This comes under equity financing, investment bank will
facilitate the process of raising money from the public through issuing shares for
the public. Both common stocks and preferred stocks would come under this
domain

Question12:
Discuss the fact that BPL is a regulated industry? What effect does this have upon
their financing plans?
Solution:

BPL- Regulated Industry

BPL is a utility industry regulated as per the rules of law. It is seen from the case itself
that companys debt to total assets ratio was at a level beyond which the financial staff
believed a downgrading of the companys bond rating would be possible.
There are various regulations for a utility industry :

Power Purchase Agreements (PPA)

Federal Energy Regulatory Commission (FERC)

As the utility industry evolves, as markets grow more volatile and as regulations change,
investors can expect more lucrative opportunities. Simultaneously, they must learn to
embrace more risk.

Conti.

Effect on financing planning

As the utility industry evolves, as markets grow more volatile and as regulations
change, it is very difficult for the company to comply PPA agreement.

Investors also expects more lucrative opportunities with the evolving utility
industry

Investors ought to keep an eye on debt levels. High debt puts a strain oncredit
ratings, weakening new power generators' ability to financecapital expenditure.
Poor credit ratings make it awfully difficult for traders to purchase energy
contracts on the open market