HIGH ROCK INDUSTRY The Debt versus Equity Financing Alternative

I.

INTRODUCTION High Rock Industries is a company which engaged in the purchase of undeveloped acreage which

was then developed for industrial use. Over the past fifteen years, the company had become the dominant mid-Atlantic developer of office parks. Kathleen Crawford is the president and CEI of Hugh Rock Industries, reflected upon the company s growth since its inception in 1975. That growth, indicated of the activity in land development in the mid-Atlantic region of the United States, carried with it a persistent need for expansion capital. The company s plan, from inception, had been deal in only the most potentially profitable land acquisition. Crawford was intent upon having the infrastructure necessary to make he company s strategy work, thus having the best people on staff was the key element. The staff had not only well-qualified accountants and marketing people, but appraisers and specialized analysts who addresed leasing, zoning requirements, and population patterns. As a result, strategy had always been defined in terms of specific competencies, which led to clearly defined products and markets. The revenue and profits of HRI increased at a steady pace, which means it provides access to higher-priced, and hopefully, better situated property, hence faster profit growth. The debentures currently outstanding with coupon rate 9.5% and carry AAA rating. Most typical firms with similar bond rating has maximum 55% in their capital structure. Kathleen Crawford was interested to a tract of land in the general vicinity of Washington DC. The land was to the west of the DC metro area along the border shared by Maryland and Virginia. The development in that area was primarily commercial and had become the site of some very-well situated office parks and federal office buildings. The area was occupied by several US offices of foreign governments and business. HRI considered the asking price of $6million to be most reasonable and they forecasted buying this land will increase HRI EBIT to 20%. The forecast was based upon the occupancy rate of commercial property in the immediate area, a forecast of commercial construction, and HRI s skill in managing such property. To acquire the land, HRI should raise the funds, and as alternatives are: Debt: 7% coupon, 15 years maturity, flotation cost $200,000, possibility of sinking fund $400,000 Equity : Market price $ 30 Preferred stock : $100 preferred stock with net price $93.5 after brokerage fees, with stock yield 8%

37%. Equity Calculated by ROE = rs= Net income / Common equity = $2. Preferred stock Known as dividend yield = rps = 8% Based on debt to asset ratio.16% b. 2. found that rd = 11. the reccomendation will goes to debt without sinking funds.000. and based on ROE.000.PMT=$420. Debt (ignoring the sinking fund) Calculated with Excel.488/ $34.000.37%(1-30%) = 5. YOU DON T HAVE to calculate (Spreadsheet is attached as Table 1) The cost of capital was calculated as below: a.000. for N=15. The proposed acqusition seem to fit HRI s business pattern as HRI is engaged in the purchase of undeveloped acreage which was then developed for industrial use. The acquisition proposal land located in urban areas that has a good development in commercial and had become the site of some very-well situated office parks and federal office buildings.91% c. risk. and income. .000. hence cost of debt after tax = 7.000. Icoupon=7%.II.000. for N=15. PV=$5. Debt (with sinking fund) Calculated with Excel. from inception.000. common stock and preferred stock alternatives has lower value compare to debt alternatives. debt without sinking funds has the less cost of capital. FV=$6. MAIN ISSUE HRI has to choose which alternative is best to the company to raise the S6million funds. But.01% d. had been deal in only the most potentially profitable land acquisition. based on cost of capital.000. found that rd = 7. common stock and preferred stock alternatives has higher value compare to debt alternatives.PMT=$820.3%(1-30%) = 7. FV=$6. The acquisition considered as a profitable project by the assessment of her high skill financial staff as it will increase the EBIT to 20% which in line with the company s plan. in this case.042. especially in office parks.800. PV=$5. III. we will highlighted more to flexibility. however the value for debt alternatives was still within range (less than 55%). hence cost of debt after tax = 11. Same thing goes for TIE. QUESTIONS 1. debt has the highest ROE among all alternatives. Thus.800. Icoupon=7%.3%. There are several criterias to analyse the financial decision.000 = 6.

4.000 200 F = 6.000 PMT = 7% * 6. the other useful information is net income and total common equity because they are used to calculate ROE and also yield on preferred stock and the tax rate. If the company is risky.3.JUST LIKE AMORTIZATION ! IT S NOT GONNA BE THE SAME FOR EACH YEAR! . (Spreadsheet is attached) Our findings are that through the additional debt. so that s why the company unlikely use the sinking fund.000 = 420 with PMT = 420 PMT2 = 7% * 5600 . so the company still has the capacity to increase its debt. the fund reduces the risk the organization will default when the principal is due: it reduces credit risk. it will increase the debt ratio but it also increases the TIE ratio. it has the benefit that the principal of the debt or at least part of it. it is a fund into which money can be deposited. because the organization has an option on the bonds: the firm will choose to buy back discount bonds (selling below par) at their market price. But in this case. The calculation before and after the new capital is required through debenture. As seen in Table 1. the company bond rating is triple A which is considered as less risky company. Besides that. will be available when due. Although debt ratio increases but it still below the industry ratio. More specifically. debentures or stocks can be retired. while exercising its option to buy back premium bonds (selling above par) at par. it will effect in decision. All informations that stated in debt alternatives are useful. However. this comes at a cost to creditors. if the bonds are callable. Thus. The income statement and balance sheet data also supporting the calculation. For the organization retiring debt. then investor required higher return so company can consider of using sinking fund in secure their debt holder position. the sinking funds will add aditional expense to firms and will increase the cost of debt. A sinking fund is a method by which an organization sets aside money over time to retire its indebtedness. so that over time its preferred stock. without PV = 6. can be showed in Table 2. 5. supported with HRI reputation within the financial community. For the creditors.

For HRI case. HRI only can have space for increasing debt up to 7% from current.6. But however. the company only has the capacity to increase its debt not more than 2%. and ROE has the highest value among all alternatives. TIE.. cost of capital. and income are major factors in selecting a financing alternative. and ROE. 9. risk and income can be considered and measured as below: Flexibility: Does increasing debt restrict the firm for seeking more debt in the future due to high debt levels? Does increasing debt violate loan covenants or result in the potential for loan covenants to be violated with poor performance? Measured by debt to asset ratio compare to industry limit. additional $6million in debt will add to 53. meanwhile the cost of capital is lowest compare to others. But we can t count the EPS since there is no price FRICTO!! THEORIES IV.66% before the debt is acquired. CONCLUSION AND RECOMMENDATION Flexibility. they can consider to use debt without sinking funds as their D/A ratio and TIE were still in industry limit. 7. the investment bankers also should explain if additional debt will affect current HRI bond ratings. Risk (financial): Can the company meet debt service (interest and principal) especially when times are tough? How volatile are the company s earnings and cash flow? Measured by TIE. Industry comparable ratios. The additional informations that would have been useful in HRI analysis are dividend and growth for common stock to calculate rs more accurately and precisely.02% which still below the maximum limit. HRI can consider to ignore sinking funds regarding to its existing level of interest rates and its reputation within the financial community. cost of capital. Low flexibility. If after this company still have plan to issue long term debt. risk. 8. Income: How do the different financing alternatives impact earnings per share (EPS) and return on equity (ROE)? Measured by ROE and EPS. The flexibility. As addition with Answer for Question number 3. The estimate level of EBIT after purchase is useful in calculating new ROE and TIE. The current debt to asset ratio is 47. 10. As HRI want to mantain the debt to asset ratio in range 48-55%.. Company might give expected dividend and growth to calculated cost of equity more . They can be measured through D/A ratio.!!! because its already closed to the maximum ratio.

. In future. company has to solved its debt or consider raised equity to get additional funds needed.precisely.

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