Increasing the debt finance of a company relative to equity finance increases its financial risk, and therefore the company will need to be able to bear the consequences of this increased risk. However, companies face both financial risk, which increases as the debt levels in the capital structure increase, and business risk, which is present in a company due to the nature of its business.

In the case of Conejo Co, it could be argued that as its profits and cash flows have stabilised, the company’s business risk has reduced, in contrast to early in its life, when its business risk would have been much higher due to unstable profits and cash flows. Therefore, whereas previously Conejo Co was not able to bear high levels of financial risk, it is able to do so now without having a detrimental impact on the overall risk profile of the company. It could therefore change its capital structure and have higher levels of debt finance relative to equity finance.

The predatory acquisition of one company by another could be undertaken for a number of reasons. One possible reason may be to gain access to cash resources, where a company which needs cash resources may want to take over another company which has significant cash resources or cash generative capability. Another reason may be to increase the debt capacity of the acquirer by using the assets of the target company. Where the relative level of debt finance is increased in the capital structure of a company through a financial reconstruction, like in the case of Conejo Co, these reasons for acquiring a company may be diminished. This is because the increased levels of debt would probably be secured against the assets of the company and therefore the acquirer cannot use them to raise additional debt finance, and cash resources would be needed to fund the higher interest payments.

Many tax jurisdictions worldwide allow debt interest to be deducted from profits before the amount of tax payable is calculated on the profits. Increasing the amount of debt finance will increase the amount of interest paid, reducing the taxable profits and therefore the tax paid. Modigliani and Miller referred to this as the benefit of the tax shield in their research into capital structure, where their amended capital proposition demonstrated the reduction in the cost of capital and increase in the value of the firm, as the proportion of debt in the capital structure increases.

Report to the board of directors (BoD), Conejo Co
Introduction
This report discusses whether the proposed financial reconstruction scheme which increases the amount of debt finance in Conejo Co would be beneficial or not to the company and the main parties affected by the change in the funding, namely the equity holders, the debt holders and the credit rating companies. Financial estimates provided in the appendices are used to support the discussion.
Impact on Conejo Co
Benefits to Conejo Co include the areas discussed in part (a) above and as suggested by the CFO. The estimate in appendix 3 assumes that the interest payable on the new bonds and the extra interest payable on the existing bonds are net of the 15% tax. Therefore, the tax shield reduces the extra amount of interest paid. Further, it is likely that because of the large amount of debt finance which will be raised, the company’s assets would have been used as collateral. This will help protect the company against hostile takeover bids. Additionally, proposal 2 (appendix 3) appears to be better than proposal 1, with a lower gearing figure and a higher earnings per share figure. However, this is dependent on the extra investment being able to generate an after-tax return of 12% immediately. The feasibility of this should be assessed further.
Conejo Co may also feel that this is the right time to raise debt finance as interest rates are lower and therefore it does not have to offer large coupons, compared to previous years. Appendix 1 estimates that the new bond will need to offer a coupon of 3·57%, whereas the existing bond is paying a coupon of 5·57%.
The benefits above need to be compared with potential negative aspects of raising such a substantial amount of debt finance. Conejo Co needs to ensure that it will be able to finance the interest payable on the bonds and it should ensure it is able to repay the capital amount borrowed (or be able to re-finance the loan) in the future. The extra interest payable (appendix 3) will probably not pose a significant issue given that the profit after tax is substantially more than the interest payment. However, the repayment of the capital amount will need careful thought because it is significant.
The substantial increase in gearing, especially with respect to proposal 1 (appendix 3), may worry some stakeholders because of the extra financial risk. However, based on market values, the level of gearing may not appear so high. The expected credit migration from A to BBB seems to indicate some increase in risk, but it is probably not substantial.
The BoD should also be aware of, and take account of, the fact that going to the capital markets to raise finance will require Conejo Co to disclose information, which may be considered strategically important and could impact negatively on areas where Conejo Co has a competitive advantage.
Reaction of credit rating companies
Credit ratings assigned to companies and to borrowings made by companies by credit rating companies depend on the probability of default and recovery rate. A credit migration from A to BBB means that Conejo Co has become riskier in that it is more likely to default and bondholders will find it more difficult to recover their entire loan if default does happen. Nevertheless, the relatively lower increase in yield spreads from A to BBB, compared to BBB to BB, indicates that BBB can still be considered a relatively safe investment.
Duration indicates the time it takes to recover half the repayments of interest and capital of a bond, in present value terms. Duration measures the sensitivity of bond prices to changes in interest rates. A bond with a higher duration would see a greater fluctuation in its value when interest rates change, compared to a bond with a lower duration. Appendix 2 shows that a bond which pays interest (coupon) and capital in equal annual instalments will have a lower duration. This is because a greater proportion of income is received earlier and income due to be received earlier is less risky. Therefore, when interest rates change, this bond’s value will change by less than the bond with the higher duration. The CEO is correct that the bond with equal annual payments of interest and capital is less sensitive to interest rate changes, but it is not likely that this will be a significant factor for a credit rating company when assigning a credit rating.
A credit rating company will consider a number of criteria when assigning a credit rating, as these would give a more appropriate assessment of the probability of default and the recovery rate. These criteria include, for example, the industry within which the company operates, the company’s position within that industry, the company’s ability to generate profits in proportion to the capital invested, the amount of gearing, the quality of management and the amount of financial flexibility the company possesses. A credit rating company will be much less concerned about the manner in which a bond’s value fluctuates when interest rates change.
Impact on equity holders
The purpose of the financial reconstruction would be of interest to the equity holders. If, for example, Conejo Co selects proposal 1 (appendix 3), it may give equity holders an opportunity to liquidate some of their invested capital. At present, the original members of the company hold 40% of the equity capital and proposal 1 provides them with the opportunity to realise a substantial capital without unnecessary fluctuations in the share price. Selling large quantities of equity shares in the stock exchange may move the price of the shares down and cause unnecessary fluctuations in the share price.
If, on the other hand, proposal 2 (appendix 3) is selected, any additional profits after the payment of interest will benefit the equity holders directly. In effect, debt capital is being used for the benefit of the equity holders.
It may be true that equity holders may be concerned about the increased risk which higher gearing will bring, and because of this, they may need higher returns to compensate for the higher risk. However, in terms of market values, the increased gearing may be of less concern to equity holders. Conejo Co should consider the capital structure of its competitors to assess what should be an appropriate level of gearing.
Equity holders will probably be more concerned about the additional restrictive covenants which will result from the extra debt finance, and the extent to which these covenants will restrict the financial flexibility of Conejo Co when undertaking future business opportunities.
Equity holders may also be concerned that because Conejo Co has to pay extra interest to debt holders, its ability to pay increasing amounts of dividends in the future could be affected. However, appendix 3 shows that the proportion of interest relative to after-tax profits is not too high and any concern from the equity holders is probably unfounded.
Impact on debt holders
Although the current debt holders may be concerned about the extra gearing which the new bonds would introduce to Conejo Co, appendix 1 shows that the higher coupon payments which the current debt holders will receive would negate any fall in the value of their bonds due to the credit migration to BBB rating from an A rating. Given that currently Conejo Co is subject to low financial risk, and probably lower business risk, it is unlikely that the current and new debt holders would be overly concerned about the extra gearing. The earnings figures in appendix 3 also show that the after-tax profit figures provide a substantial interest cover and therefore additional annual interest payment should not cause the debt holders undue concern either.
The current and new debt holders would be more concerned about Conejo Co’s ability to pay back the large capital sum in five years’ time. However, a convincing explanation of how this can be achieved or a plan to roll over the debt should allay these concerns.
The current and new debt holders may be concerned that Conejo Co is not tempted to take unnecessary risks with the additional investment finance, but sensible use of restrictive covenants and the requirement to make extra disclosures to the markets when raising the debt finance should help mitigate these concerns.
Conclusion
Overall, it seems that the proposed financial reconstruction will be beneficial, as it will provide opportunities for Conejo Co to make additional investments and/or an opportunity to reduce equity capital, and thereby increasing the earnings per share. The increased gearing may not look large when considered in terms of market values. It may also be advantageous to undertake the reconstruction scheme in a period when interest rates are low and the credit migration is not disadvantageous. However, Conejo Co needs to be mindful of how it intends to repay the capital amount in five years’ time, the information it will disclose to the capital markets and the impact of any negative restrictive covenants.
Report compiled by:
Date
Appendices:
Appendix 1: Change in the value of the current bond from credit migration and coupon rate required from the new bond (Question (b) (i))
Spot yield rates (yield curve) based on BBB rating

Bond value based on BBB rating
$5·57 x 1·0220^–1 + $5·57 x 1·0251^–2 + $105·57 x 1·0284^–3 = $107·81
Current bond value = $107·80
Although the credit rating of Conejo Co declines from A to BBB, resulting in higher spot yield rates, the value of the bond does not change very much at all. This is because the increase in the coupons and the resultant increase in value almost exactly matches the fall in value from the higher spot yield rates.
Coupon rate required from the new bond
Take R as the coupon rate, such that:
Take R as the coupon rate, such that:
($R x 1·0220^–1) + ($R x 1·0251^–2) + ($R x 1·0284^–3) + ($R x 1·0325^–4) + ($R x 1·0362^–5) + ($100 x 1·0362^–5) = $100
4·5665R + 83·71 = 100
R = $3·57
Coupon rate for the new bond is 3·57%.
If the coupon payments on the bond are at a rate of 3·57% on the face value, it ensures that the present values of the coupons and the redemption of the bond at face value exactly equals the bond’s current face value, based on Conejo Co’s yield curve.
Appendix 2: Macaulay durations (Question (b) (ii))
Macaulay duration based on annual coupon of $3·57 and redemption value of $100 in year 5:
[($3·57 x 1·0220^–1 x 1 year) + ($3·57 x 1·0251^–2 x 2 years) + ($3·57 x 1·0284^–3 x 3 years) + ($3·57 x 1·0325^–4 x 4 years) + ($103·57 x 1·0362^–5 x 5 years)]/$100 = [3·49 + 6·79 + 9·85 + 12·57 + 433·50]/100 = 4·7 years
Macaulay duration based on fixed annual repayments of interest and capital:
Annuity factor: (3·57%, 5 years) = (1 – 1·0357–5)/0·0357 = 4·51 approximately
Annual payments of capital and interest required to pay back new bond issue = $100/4·51 = $22·17 per $100 bond approximately
[($22·17 x 1·0220^–1 x 1 year) + ($22·17 x 1·0251^–2 x 2 years) + ($22·17 x 1·0284^–3 x 3 years) + ($22·17 x 1·0325^–4 x 4 years) + ($22·17 x 1·0362^–5 x 5 years)]/$100 = [21·69 + 42·20 + 61·15 + 78·03 + 92·79]/100 = 3·0 years
Appendix 3: Forecast earnings, financial position, earnings per share and gearing (Question (b) (iii))
Adjustments to forecast earnings