Section B – TWO questions ONLY to be attempted
Tippletine Co is based in Valliland. It is listed on Valliland’s stock exchange but only has a small number of shareholders. Its directors collectively own 45% of the equity share capital.
Tippletine Co’s growth has been based on the manufacture of household electrical goods. However, the directors have taken a strategic decision to diversify operations and to make a major investment in facilities for the manufacture of office equipment.
Details of investment
The new investment is being appraised over a four-year time horizon. Revenues from the new investment are uncertain and Tippletine Co’s finance director has prepared what she regards as cautious forecasts. She predicts that it will generate $2 million operating cash flows before marketing costs in Year 1 and $14·5 million operating cash flows before marketing costs in Year 2, with operating cash flows rising by the expected levels of inflation in Years 3 and 4.
Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to 4.
The new investment will require immediate expenditure on facilities of $30·6 million. Tax allowable depreciation will be available on the new investment at an annual rate of 25% reducing balance basis. It can be assumed that there will either be a balancing allowance or charge in the final year of the appraisal. The finance director believes the facilities will remain viable after four years, and therefore a realisable value of $13·5 million can be assumed at the end of the appraisal period.
The new facilities will also require an immediate initial investment in working capital of $3 million. Working capital requirements will increase by the rate of inflation for the next three years and any working capital at the start of Year 4 will be assumed to be released at the end of the appraisal period.
Tippletine Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any tax losses on the investment can be assumed to be carried forward and written off against future profits from the investment.
Predicted inflation rates are as follows:
Calculate the adjusted present value for the investment on the basis that it is financed by the subsidised loan and conclude whether the project should be accepted or not. Show all relevant calculations.
4 Issue costs
Debt: ($30,600,000/0·96) = $31,875,000
Debt issue costs: $31,875,000 x 0·04 = $1,275,000
5 Tax shield on loan
Use PV of an annuity (PVA) for years 2 – 5 at 5% (assume 5% is cost of debt).
(Note: The risk-free rate of 2·5% could also be used for discounting.)
Subsidised loan: $30,600,000 x (0·025 – 0·003) x 0·3 x (4·329 – 0·952) = $682,000
6 Subsidy
Benefit = $30,600,000 x (0·05 – 0·022) x 3·546 = $3,038,000
Tax relief lost = $30,600,000 x (0·05 – 0·022) x 0·3 x (4·329 – 0·952) = $868,000
7 Financing side effects
Discuss the issues which Tippletine Co’s shareholders who are not directors would consider if its directors decided that the new investment should be financed by the issue of convertible loan notes on the terms suggested.
Note: You are not required to carry out any calculations when answering part (b).
Advantages of convertible loan notes
The investors may be happy that directors are demonstrating their commitment to the company by subscribing to convertible loan notes. The conversion rights mean that these directors will benefit if the share price increases, aligning their interests with shareholders.
The conversion terms also mean that the loan notes will not necessarily have to be repaid in a few years’ time. This may be significant if Tippletine Co does not have the cash available for redemption then.
Drawbacks of convertible loan notes
The convertible loan notes would be treated as debt, increasing Tippletine Co’s gearing, which may concern the other shareholders. The interest on the convertible loan notes will be payable before dividends and may leave less money for distribution to shareholders. Shareholders may doubt whether the higher interest burden on the convertible loan notes compared with the subsidised loan is compensated for by the lower costs of Tippletine Co not having to fulfil the government’s requirements.
The other shareholders may be concerned by the interest rate on the convertible notes being Tippletine Co’s normal cost of borrowing. The option to convert is an advantage for convertible loan note holders. They would often effectively pay for this option by receiving a lower rate of interest on the loan notes.
Shareholders would want to assess how likely conversion would be, that is how likely it would be the share price will rise above $2·75. The option to convert may also change the balance of shareholdings, giving the directors who held the notes a greater percentage of share capital and possibly more influence over Tippletine Co. The other shareholders may be unhappy with this.
The shareholders may also have reservations about the loan note holders having the option to redeem if Tippletine Co’s share price is low. This reduces the risk of providing the finance from the loan note holders’ viewpoint. However, if the share price is low, Tippletine Co’s financial results and cash flows may be poor and it may struggle to redeem the loan notes. Shareholders may also be concerned that there is no cap the other way, allowing Tippletine Co to force conversion if the share price reaches a high enough level.
(Note: Credit will be given for alternative relevant discussion)