Question Tag: Debt Instruments

Effe is a Nigerian company specialising in the provision of information systems solutions to large corporate organisations. It is going through a period of rapid expansion and requires additional funds to finance the long-term working capital needs of the business.

Effe has issued one hundred million N1 ordinary shares, which are listed on the stock market at a current market price of N15 with typical increases of 10% per annum expected in the next five years. Dividend payout is kept constant at a level of 10% of post-tax profits. Effe also has N1,000 million of bank borrowings.

It is estimated that a further N300 million is required to satisfy the funding requirements of the business for the next five-years beginning July 1, 2021. Two major institutional shareholders have indicated that they are not prepared to invest further in Effe at the present time and so a rights issue is unlikely to succeed. The directors are therefore considering various forms of debt finance. Three alternative structures are under discussion as shown below:

• Five-year unsecured bank loan at a fixed interest rate of 7% per annum;
• Five-year unsecured bond with a coupon of 5% per annum, redeemable at par and issued at a 6% discount; and
• A convertible bond, issued at par, with an annual coupon rate of 4.5% and a conversion option in five years’ time of five shares for each ₦100 nominal of debt.

There have been lengthy boardroom discussions on the relative merits of each instrument. Summarised below are the queries of three different directors concerning the instruments.

Director A: “The bank loan would seem to be more expensive than the unsecured bond. Is this actually the case?”
Director B: “Surely, the convertible bond would be the cheapest form of borrowing with such a low interest rate?”
Director C: “If we want to increase our equity base, why use a convertible bond, rather, than a straight equity issue?”

Required:

a. Write a response to the queries raised by the three directors and advise on the most appropriate financing instrument for Effe. In your answer, include calculations of appropriate yield for each instrument. Ignore tax. (15 Marks)
b. Advise a prospective investor in the five-year unsecured bond issued by Effe on what information he should expect to be provided with and what further analysis he should undertake in order to assess the credit worthiness of the proposed investment. (5 Marks)