Toltuck Co is a listed company in the building industry which specialises in the construction of large commercial and residential developments. Toltuck Co had been profitable for many years, but has just incurred major losses on the last two developments which it has completed in its home country of Arumland. These developments were an out-of-town retail centre and a major residential development. Toltuck Co’s directors have blamed the poor results primarily on the recent recession in Arumland, although demand for the residential development also appears to have been adversely affected by it being located in an area which has suffered serious flooding over the last two years.
As a result of returns from these two major developments being much lower than expected, Toltuck Co has had to finance current work-in-progress by a significantly greater amount of debt finance, giving it higher gearing than most other construction companies operating in Arumland. Toltuck Co’s directors have recently been alarmed by a major credit agency’s decision to downgrade Toltuck Co’s credit rating from AA to BBB. The directors are very concerned about the impact this will have on the valuation of Toltuck Co’s bonds and the future cost of debt.
The following information can be used to assess the consequences of the change in Toltuck Co’s credit rating.
Toltuck Co has issued an 8% bond, which has a face or nominal value of $100 and a premium of 2% on redemption in three years’ time. The coupon on the bond is payable on an annual basis.
The government of Arumland has three bonds in issue. They all have a face or nominal value of $100 and are all redeemable at par. Taxation can be ignored on government bonds. They are of the same risk class and the coupon on each is payable on an annual basis. Details of the bonds are as follows:
Calculate the valuation and yield to maturity of Toltuck Co’s $100 bond under its old and new credit ratings.
The government yield curve can be estimated from the data available:
Discuss the factors which may have affected the credit rating of Toltuck Co published by the credit agency
The credit agency will have taken the following criteria into consideration when assessing Toltuck C’s credit rating:
Country
Toltuck Co’s debt would not normally be rated higher than the credit ratings of its country of origin, Arumland. Therefore the credit rating of Arumland should normally be at least AA. The rating will also have depended on Toltuck Co’s standing relative to other companies in Arumland. The credit agency may have reckoned that Toltuck Co’s recent poor results have weakened its position.
Industry
The credit agency will have taken account of the impact of the recession on property construction companies generally in Arumland. Toltuck Co’s position within the industry compared with competitors will also have been assessed. If similar recent developments by competitors have been more successful, this is likely to have had an adverse impact on Toltuck Co’s rating.
Management
The credit agency will have made an overall assessment of management and succession planning at Toltuck Co. It will have looked at business and financing strategies and planning and controls. It will also have assessed how successful the management has been in terms of delivering financial results. The credit agency may have believed the poor returns on recent developments show shortcomings in management decision-making processes and it may have rated the current management team poorly.
Financial
The credit agency will have analysed financial results, using measures such as return on capital employed. The agency will also have assessed possible sources of future earnings growth. It may have been sceptical about prospects, certainly for the short term, given Toltuck Co’s recent problems.
The credit agency will also have assessed the financial position of Toltuck Co, looking at its gearing and working capital management, and considering whether Toltuck Co has enough cash to finance its needs. The agency will also have looked at Toltuck Co’s relationship with its bankers and its debt covenants, to assess how flexible its sources of finances are if it comes under stress. It may well have been worried about Toltuck Co’s gearing being higher than the industry average and concerned about the high levels of cash it needs to finance operations. It will also have assessed returns on developments-in-progress compared with commitments to repay loans. Greater doubt about Toltuck Co’s ability to meet its commitments is likely to have been a significant factor in the fall in its rating.
The agency will also have needed reassurance about the quality of the financial information it was using, so it will have looked at the audit report and accounting policies.
Discuss the impact of the fall in Toltuck Co’s credit rating on its ability to raise financial capital and on its shareholders’ return.
Toltuck Co may not have increased problems raising debt finance if debtholders do not react in the same way as the credit rating agency. They may attach different weightings to the criteria which they use. They may also come to different judgements about the quality of management and financial stability. Debtholders may believe that the recent problems Toltuck Co has had generating returns may be due more to external factors which its management could not have controlled.
However, it is probable that the fall in Toltuck Co’s credit rating will result in it having more difficulty raising debt finance. Banks may be less willing to provide loans and investors less willing to subscribe for bonds. Even if debt finance is available, it may come with covenants restricting further debt or gearing levels. This will mean that if Toltuck Co requires substantial additional finance, it is more likely to have to make a rights issue or issue new equity on the stock market. Shareholders may be faced with the choice of subscribing large amounts for new capital or having their influence diluted. This may particularly worry the more cautious shareholders.
Even if Toltuck Co can obtain the debt it needs, the predicted increase in yield to maturity may be matched by debtholders demanding a higher coupon rate on debt. This will increase finance costs, and decrease profits and earnings per share, with a possible impact on share price. It will also mean that fewer funds are available for paying dividends. Toltuck Co has been faced with difficult decisions on balancing investment expenditure versus paying dividends and these difficulties may well increase.
Additional debt may have other restrictive covenants. They may restrict Toltuck Co’s buying and selling of assets, or its investment strategy. Restrictions on Toltuck Co’s decisions about the developments it undertakes may impact adversely on shareholder returns.
Loan finance or bonds will also come with repayment covenants. These may require Toltuck Co to build up a fund over time which will be enough to redeem the debt at the end of its life. Given uncertainties over cash flows, this commitment to retain cash may make it more difficult to undertake major developments or pay an acceptable level of dividend.
The fall in Toltuck Co’s credit rating may result in its cost of equity rising as well as its cost of debt. In turn, Toltuck Co’s weighted average cost of capital will rise. This will affect its investment choices and hence its ability to generate wealth for shareholders. It may result in Toltuck Co prioritising developments offering better short-term returns. This may suit the more cautious shareholders, but the current majority may worry that Toltuck Co will have to turn down opportunities which offer the possibility of high returns.