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The Debt versus Equity Financing Alternative
High Rock Industries
Kathleen Crawford, president and CEO of High Rock Industries, reflected upon the company's growth since its inception in 1975. That growth, indicative of the activity in land development in the mid-Atlantic region of the United States, carried with it a persistent need for expansion capital. High Rock Indust.ries (l-IRl), named for the founder's tiny hometown in Southeastern Virginia, was engaged in the purchase of undeveloped acreage which was then developed for industrial use. Over the post fifteen yenrs, the company had become the dominant mid-Atlantic developer of oftice parks. TI1e company began with Crawford's grandfather's purchase of farmland in the 1960s for the purpose of residential development. As the rural areas of Maryland, Virginia, and North Carolina declined in population, and hence the ability to attract industry, Crawford's strategy had to be revised. Much of the originally purchased land was liquidated, and the cash was used to purchase land within a reasonable proximity of urban areas. The company wanted to take advantage of business relocations of many com panics from the industrial region which had Cleveland, Ohio as its approximate center. By 1975, the complexity of the business demanded incorporation and an appropriate managerial staff It was at that time that Crawford finished her lvlBA and was in search of meaningful employment. Her grandfather was eager to tum the business over to her so that he could spend more time enjoying travel lind his rare book collection. While some land development firms had excess acreage, HR.I did not. The economic period which followed the oil embargo of 1973 brought about many changes in the way business was done in the United States. The changes, however, could be broadly categorized as locational changes, and revisions to the scale of businesses. Many businesses were changing locutions for any number of reasons, and the operations of many companies were becoming smaller. It so happened, however, that the land owned by HR.! was located in the region to which many businesses were moving. The company's plan, from inception, had been to deal in only the most potentially profitable land acquisitions. While such a strategy appeared obvious 10 some observers, its execution was another matter altogether. Crawford was intent upon having the infrastructure necessary to make the company's strategy work, To that end, 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 addressed leasing, zoning requirements, and population patterns. As a result of the level of expertise which was found in the company, strategy had always been defined in terms of specific competencies, which led to clearly defined products and markets.
TIle attention ofHRl turned to the means by which the funds would be raised.Case 31 High Rock Industries . the revenue and profits of HRI increased at a steady pace. Such operating characteristics inclr Jed earnings stability. respectively. which often means even faster profit growth..l. the area was well served by the area's rapid transit system. The debentures currenlly outstanding have a coupon rate of 9~ percent and carry a triple A rating.. That is. Most firms with which HRI competed had similar bond ratings and capital structures which included no more than 55 percent debt.:::: r' ". which are provided below. Crawford's financial staff assured her of on increase in HRI's earnings before interest and taxes (EBIT) of 20 percent. The firm's equity is widely held due to active over-the-counter trading. Within the commercial land development industry. based upon the present revenue which the building generated. for HRI. but lenders or equity investors stood ready to commit funds on short notice based upon the reputation of the firm. ~ ~""- . strong profits provide access to higher-priced. identity a desirable property and arrange for financing. In addition. In fact. Their success seemed to stem from the personality and connections of the principal shareholder/manager. better-situated property. and ~l's skill in managing such property. On the basis of the foregoing. The small tract of land in which Crawford had become interested was occupied by a well-constructed building occupied by good tenants. the land was 10 the west of the D. This post-purchase EBIT forecast was based upon the occupancy rate of commercial property in the immediate area. The development in that area was primarily commercial and had become the site of some very well-situated office parks and federal office buildings. Thus. some of the most profitable and well-run firms were thinly managed. the area was occupied by several U. TIle investment bank with which I-IRI usually worked outlined possibilities and conditions for the acquisition of the $6 million.. or so it seemed. however.. HRl had been in very close contact with the property's owners and il appeared that a deal could be made before the property was placed with a commercial real estate broker. Tables 1 and 2 present a balance sheet and income statement. The current trading range of the stock is between $32 and $34 per share. In addition. This. In recent weeks Kathleen Crawford learned of a tract ofland which had become available in the general vicinity of Washington. As a result of that phenomenon. the company's operating characteristics placed it among a select group of stable companies for which there were reliable data provided by industry analysts. they saw I! continuing need for long-term funds in the future.S. firms' capital structures differed widely. In these cases there was not necessarily Aline of credit. HR1 was in a most enviable position relative to the competition. There was also a parking garage owned by another company. offices of foreign governments and businesses. As is typical in the land acquisition and development business. The idea of stand-by financing was often cited as a reason for the success of many firms. The idea of having connections in the business referred most often to the ability to simultaneously. according to a nationally known bond rating agency. a forecast of commercial construction. and revenue and earnings growth. In addition.. This was due in part to the managerial structure of the firms which made up this particular industry. The company's financial staff believed that the present debt level of the finn was within acceptable limits. industry Average 31-2 . implies no lack of ethics and standards in the business. metro area along the border shared by Maryland and Virginia. While the normal process of property acquisition would include a brokerage service. HRl considered the asking price of $6 million to be most reasonable.C. D. In terms ofHR. and hopefully. method of financing. in addition.C. the current situauon was one of those obviously fortuitous circumstances that demanded a quick decision.
000 20.2lQ holdings of undeveloped Current liabilities Long-term debt Common stock ($20 par) Retained earnings Total liabilities and e. $500 25.Case 31 High Rock Industries capitalization had less meaning than did SHY. Current assets Net fixed assets While HRI hod no preferred stock in its capital structure at present. 1991 (SOGOs) . Primarily 15.000 per year..000 Tota! assets Note: • . given the existing level of interest rates and the reputation of'Hklwithin the financial community. could be placed with an insurance company.000 8000 $5)..115 year maturity.5QQ 31-3 . Preferred HR.. this did not rule out (he possibility of such an issue. TABLE I High Rock Industries Balance Sheet December 31. (There are no explicit interest charges for current Iiabiliiies. The coverage ratios were rei iable due to the fact that most firms held fairly constantfinancing patterns even though such patterns differed among [irrns. All parties concerned thought this unlikely. with a 7 percent coupon and . One-hundred-dollars per share preferred stock could be sold 10 net the company $93. Stock: .:q_ui!)' acreage and leased property.50 per share afler brokerage fees. $\. The yield on preferred stock of equivalent quality is 8 percent. The Alternatives Six million dollars of straight debentures. coverage ratios for a particular firm.500 52.) An equity issue could be sold to the public.000..1. There was also the possibility of a sinking fund of $400.I would net $30. The flotation cost on such an issue would be $200.
ill_.000) $2.700 (2. J992 Revenue Less: Cost of sales EBIT Less: Interest Taxable income Less: Taxes (JO%) Profit after-tax $10. What information and data are most useful in answering Question 2? 4.000.410.375. information would have been useful in your analysis of HRl? 7. What additional Explain. 5. in addition to the specifics should be provided by the investment bankers? of the financing alternatives. 8.589.035.l Case 31 High Rock Industries TA'BLE 2 High Rock Industries Income Statement December Ll.710) li. preferred stock.700 (610. then comment upon the meaning and usefulness of a probability estimate of the level of EBIT after the purchase.300) $4. Consider your answers to Questions 2 and 3 above. What is the effect of a sinking fund requirement 2? Why might interest rate levels or company of a sinking fund? upon your calculations in Question risk factors influence the imposition 6. Discuss your findings. or c-ommon equity? What are the relevant decision criteria? 3.29___Q QUESTIONS I. Is there information.. Assume a 20 percent increase in current liabilities and a 20 percent increase in CUtTCn! assets. Calculate HRl's debt to total assets ratio and the times interest earned ratio before and after the new capital is acquired. Docs the proposed acquisition seem to fit HRI's business pattern? Why or why not? 2. Should the proposed acquisition be financed with debt.000 (5. that 31-4 .
risk. If such flexibility. and income are major factors in selecting a financing alternative.Case 31 9 High Rock Industries If the stable developers such as HRl have a total debt-to-total assets ratio in the range of 48-55 percent. how much flexibility for future financing will HRl have if debt is issued at present? 10. how should these considerations be defined and measured? -' 31-5 .