- 20 Marks
Question
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)
Answer
Response to Board Members:
Director A:
- The redemption yield (YTM) is a useful metric for comparing the cost of the loan and bond on the same basis.
- YTM is the internal rate of return (IRR) of the cash flows under a debt instrument, accounting for the time value of money.
- The unsecured bond is slightly cheaper than the loan, with a redemption yield of 6.45% compared to the bank loan’s fixed rate of 7%.
- This difference is expected, as the bond is marketed to a wider investor base, enabling finer rates.
- However, bond issuance typically incurs higher costs due to the required publicity and underwriting, which must also be considered.
Director B:
- Considering the coupon rate alone, the convertible bond appears cheaper than the unsecured bond due to its lower interest cost.
- If the share price grows as projected (10% annually), the convertible bond will convert to shares worth ₦120.80 after five years, implying a capital gain of ₦20.80 per ₦100 nominal. This represents an annualized yield of 3.85%.
- Combined with the 4.5% coupon, the overall yield of the convertible bond is 8.04%.
- Compared to the unsecured bond and bank loan, the convertible bond is the most expensive option.
- Additionally, after conversion, the company will likely incur dividend payments on the new shares, increasing its cost of capital as equity financing generally has a higher cost than debt.
Director C:
- Current investor hesitancy, highlighted by the institutional shareholders’ unwillingness to invest further, suggests market concerns about Effe’s growth potential.
- A convertible bond offers flexibility for investors, allowing them to opt for conversion into equity only if the company performs well over the next five years.
- The company benefits from lower financing costs during the bond’s term and the potential to boost its equity base post-conversion, aligning with growth and performance improvements.
Recommendation:
For a rapidly expanding entity like Effe, the convertible bond is the most appropriate financing option. It offers low-cost finance for five years, provides investors with the flexibility to convert to equity if the company performs well, and supports the company’s goal of increasing its equity base by the end of the bond period.
Workings
b) In assessing creditworthiness, a prospective investor should be provided with the following information:
• Financial statements for the last three years;
• Cash flow forecasts;
• Long- and short-term ratings from rating agencies of this and similar entities’ bonds;
• Business prospects;
• Prospects for the market sector and undertake the following analyses:
• Calculate ratios (gearing, interest cover, dividend cover, working capital ratios);
• Analyse free cash flow; and
• Carry out a risk assessment of the business and the market sector.
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