RIL FINANCING DECISION

Rainbow International Limited (RIL) is an India based IT company that offers software solutions
to financial institutions in USA and Europe. The company incorporated in 2014 and has been
rapidly growing since its inception. In terms of operations, the company is a small sized IT firm
but it is rapidly growing. RIL listed in Bombay stock exchange in 2021 and has total shares
outstanding of one million. The company’s overseas revenues have seen an impressive growth
and reached Rs. 540 s in July 2022. The total earnings of the company is currently Rs. 65
millions. The CEO of the company, Arun Agrawal is contemplating further expansion of the
business and requires Rs. 250 millions currently. As per the growth strategy of the company, RIL
will require additional Rs. 160 millions in future (i.e after around 4-5 years). The company has
till now undertaken a conservative financing policy and has used only equity financing owing to
the risk inherent in IT sector business. However, Mr. Arun now wants to use capital structure
design to maximize the value of the firm. Hence, he is considering other non-equity long term
financing alternatives.
Currently, RIL’s stock is trading at Rs. 250 at BSE and Arun thinks that the share is undervalued
due to recent COVID pandemic and the effect Ukraine war has on the Indian stock market.
However, the share price has grown at an average rate of 12% in past five years. The company
plans to increase dividend to Rs. 25 in coming year. The net profits of the company are currently
depressed due to low demand from the foreign markets. Arun thinks that if the company issues
equity then the EPS will be further diluted. Furthermore, equity issue is believed to send negative
signal to the market. The company’s balance sheet has very low fixed asset as being a IT
company it has more intangible assets. The relationship manager at the company’s bank has
informed that the bank will require collateral to offer attractive interest rate to RIL. Currently,
due to the monetary policy of Reserve Bank of India aimed at curbing raising inflation, the
market interest rates have increased resulting in increase of average yield of IT company
corporate debentures to 14 percent. Due to low investor confidence in the capital market and risk
due to increased stock market volatility, the debt securities issued by IT sector firms, especially
small firms have low demand currently. The required rate of return on RIL stock has increased to
19.5 percent currently. In terms of cost, RIL has higher proportion of variable cost relative to
fixed cost as it employs gig workers for software development and maintenance. Upon
consultation with finance manager, Mr. Arun has known that used of debt financing offers
financial leverage and other benefits. So, he is analyzing the financing that will benefit the
company. He has come up with following alternatives:
 Financing Alternatives for RIL
Financing Debenture Convertible Debenture with
Debenture Warrants
Coupon Rate 14% 11% 10.5%
Maturity 10 years 10 Years 10 Years
Face Value Rs. 1000 Rs. 1000 Rs. 1000
Call feature No Yes No
Call premium - 20% -
Call protection period - 4 years -
The convertible bonds can be converted into three shares of the RIL at the option of the
bondholders. Each debenture with warrants holder will receive one warrant per debenture which
provides the right but not obligation to the holder to purchase three shares of RIL at Rs. 270. In
order to raise the required financing, RIL has set the issue price at face value.
Required:
i. Is the RIL stock undervalued as perceived by Mr. Arun? Will you recommend RIL to issue
equity for financing? What are the benefits and demerits of equity financing for RIL? Elucidate.
ii. Calculate the conversion price, conversion premium and initial conversion value of the
convertible debenture.
iii. What will be the conversion value after five years? If the convertible bond were called at the
end of 5th years, what should the convertible debenture holder do? Explain.
iv. Calculate the holding period yield for the convertible bond holders.
v. Calculate the implied value of the conversion option and embedded call option value of
conversion feature.
vi. Calculate the primary and fully diluted EPS under the two hybrid financing alternatives.
vii. What is the current theoretical value of warrant?
viii. As a financial consultant, what recommendation will you provide to RIL for raising the
long-term capital to finance its growth? Justify with reference to advantages and disadvantages
of each financing alternative for RIL.