BAP53: Corporate Finance - Debt financing - Assessment Answer

Assignment Task

Introduction of the company

The company is a construction giant working across globe with its headquarters in Sydney, Australia. The company is dealing in all the sectors of construction which includes building industry, road making, cement, roof tiles, bricks and mortar etc. The company was founded in the year 1946. It employs 12000 workers and has a net asset base of around $.4.4 billion due to which it becomes one of the largest companies to work in Australia. The company has wide presence across the world especially in the countries like United States of America and Middle Europe. The company in the recent years has expanded its base in Asia as well. The chief executive officer of the company is Mike Kane since October, 2012. The company in the recent years has clocked the revenue of over$ 5 billion thus making it one of the largest and most successful organization in the world.

Current financial standing of the company

The current financial stranding of the company is very strong. Since the company is mainly in the construction period, the inflow of cash is very regular and the company in the past years has been able to maintain a healthy financial condition. The market valuation of the company is somewhere around AUD 3700 million. The current share value of the company is AUD 6.50. The gross margin percentage of the company for the past 5 years has been increasing. The company has shown an increasing trend in the gross margin ratio the summary of which is presented below –

summary of which is presented below – 2012 2013 2014 2015 2016

Revenue (AUD milllion) 4,716 5,209 4,455 4,298 4,311

Gross Margin % 27.4 26.9 27.5 29.3 32.1

The above chart shows that as far as the core business activities of the company is concerned, the company is on the right path and has been able to generate a healthy gross profit margin which in the current year has crossed 30%.

Having studied the gross profit margin of the company, the operating margin of the company is presented below –

2012 2013 2014 2015 2016

Operating income (AUD million) 59 -260 141 186 302

Operating margin % 1.2 -5.0 3.2 4.3 7.0

The above margin is not satisfactory for the company of size of Boral. Even though the company has shown an increasing trend in the operating margin %, the operating margin in itself is very less. However, the positive and reassuring thing about the financial condition of the company is that the growth rate the company has shown in the operating income and the operating margin is tremendous and it seems that the company will soon cross the 10 % profit margin on net on net basis which is again a very healthy sign for the overall financial status of the company.

Let us consider certain numbers to understand the cash flow of the company

2012 2013 2014 2015 2016

Operating Cash Flow Growth % YOY -61.99 120.56 72.55 -17.54 14.15

Free Cash Flow/Sales % 8.79 6.87 6.02 5.81 7.51

Free Cash Flow/Net Income -1.59 0.30 1.38 0.66 0.60

The cash flow of the company and the above trend shows that the company has had a fluctuating cash flow which in fact out of the selected last 5 years, has been negative in the two years which suggests that either the company has major purchase of fixed assets items which drained its cash flows or the collection cycle of the company is not that good which could not convert the debtors into cash in a reasonable period.

Let us see the how much the asset base of the company is able to generate return or profit with the current asset base of the company. The follow data reveals the following –

Return on Assets %

2012 2013 2014 2015 2016

Return on Assets % 2.90 -3.31 2.92 4.50 4.39

The above percentage reveals that the return on the assets of the company is 4.39 % in the latest year which means that if the company invests $100 in the capital assets for the longer terms, then the company can generate $ 4.39 out of it. This may not a very good ratio as the company of the size of Boral must have a reasonable return on the capital assets.

Return on equity

2012 2013 2014 2015 2016

Return on Equity % 5.49 -6.40 5.21 7.48 7.28

The return on equity indicates that if the investor invests in the company a $ 100 amount, then he or she gets the return of around $7.28 which is good for the investor as the bond interest rate of the government or the one which are issued by the private companies or the other listed companies is well below 5%.

Let us consider the receivable turnover ratio of the company. Under the efficiency ratio, the receivable turnover ratio of the company is very important as this ratio indicates collection cycle of the company which directly indicates how much the working capital requirement of the company would be. The better the receivable turnover ratio of the company would be, the better for the company as the company would then need to take short term borrowings from banks. The following data reveals the true position of the collection turnover ratio of the company –

Receivables Turnover

2012 2013 2014 2015 2016

Receivables Turnover 5.92 6.14 5.58 6.28 6.72

This indicates that the receivable turnover ratio of the company has been fairly stagnant. This on one side may be a good sign that the company has been able to consistently turn their debtors for cash. On the other hand, this shows that the company has not been able to improve the debtor’s collection cycle over the years which shows leniency on the part of management. The management must make sure that the average collection period of the management do not exceed to such level that the company has to borrow on short term borrowings which may lead to extra interest burden on the company.

Inventory turnover ratio

The inventory turnover ratio indicates that the company is able to exhaust the entire stock of inventory in how much period. This shows the efficiency of the company on both on the part of marketing and the production channel also. The company must maintain a reasonable level of inventory so that the company should not incur the extra storage cost and also that the company is not short on inventory at any time during the year.

Recent capital raising activity by the company

In the year 2010, the company decided to take a strategic review of its business and decided to write off AUD 290 million in the income statement following the discussions with the relevant personnel. The company also decided to raise capital from the outside market and decided to sell the stake in the company to another company named Selway. The capital raising activity is equity financing which would result in Boral able to raise close to AUD 490 million. The price of the shares of the company were decided to be AUD 4.10 which was in fact at the 16% to the latest traded share of the company which at the time of talks was AUD 4.89. The company is issued close to 120 million new shares which resulted in diluting the control of the company. The equity financing activity was solely underwritten by UBS (Sands, 2010).

The company decided to go for issuing fresh share capital instead of debt financing because the debt financing would have resulted in extra interest cost on the shoulders of the company which would have hampered the profit of the company. Other reason is that the company will have to repay the entire debt in couple of years which would disturb the capital structure of the company.

Analysis of the company’s financial strategy

The company has been able to maintain a healthy financial strategy for the purpose of raising funds from the capital market. There are fundamental differences in the debt financing and equity financing. The features of both the activities are explained below –

Debt financing

In debt financing, the company is able to generate the funds at a fixed cost or the floating cost decided by the market forces and the company then becomes bound to repay the debt and the interest up to the period of maturity of the loan taken. This could be taken from the government or the private financial institutions. The company under debt financing not only could raise the capital from the banks but also could issue debentures or bonds which are convertible or non-convertible at the end of maturity period. However, the company’s capital base is not diluted and the management and the control management of the company remains the same.

Equity financing

The equity financing is done by issuing fresh share capital in the market. This is done by either bringing initial public offer for the non-listed companies and raising the fresh capital in the capital markets or by issuing a fresh set of shares in the open market or by striking a bulk deal with another entity by selling the existing shares or by issuing new shares. Both the activities result in diluting the control of the company and it amounts to change in the management of the company in certain cases if the capital base transferred is greater than 50 %. However, under this method, the company need not repay the amount and it does not bear the burden of paying the fixed cost in the form of interest to the creditor. The company only has to pay dividend that too if it chooses to do so.

After discussing the equity and debt financing, the recent capital raising activities of the company and the general nature of the methods of how the company raises funds could be discussed as under-

As already discussed the company has raised capital in the year 2010 by issuing fresh shares in the market to the other company and diluting the control of the company. However, this is not the only way the company has raised funds in the recent years.

The balance sheet extract of the last 5 years for the company is presented below –

The company has raised long term borrowing by issuing senior US noted in the bent market in the year 2014. These are unsecured debt which means the company has not placed its assets on charge.

Recommendation to the company & Conclusion

Option at the disposal of the company

It is recommended for the company to go for equity financing instead of debt financing because of the reasons already stated above. The company has following options for the future expansion plan which are discussed as under –

1. 1. To issue fresh free shares in the market for subscription - the company can go for issuing the fresh capital in the market which would enable the company to go for the free capital which the company can keep without the fear of repayment in the coming financial years.
   2. The company can go for rights issue of shares which would enable the company to not change the number of shareholders and boost the market sentiments as well. The shareholding pattern of the company will also not change and would result in raising a reasonable level of capital for the company. The rights issue boost the market sentiments of the company because the shares are generally issued at the book value of the company and the shareholders mostly subscribe to the rights issue as the rights issue price in most cases is less than the market value of the shares.

• There are other ways to get the finance from the market. One way is to issue debentures in the market. Now, as earlier mentioned, the company has the option to issue debentures which are non-convertible in the market which puts unnecessary pressure on the company. There is other option for the company. The company as per the internal funding requirement could decide the periodicity of the debentures and the rate at which the company wants to pay the interest on. The other way and the most preferred way for the company is to go for convertible debentures at the end of the period which makes the capital of the company secure at the end of the debenture period, as the company at the end of debenture period just needs to convert the debt in to equity and issue equivalent shares to the debenture holders. The company can also have two options in this category.

One is to issue optional convertible debentures which can be exercised by the holders at the end of the period or any time during the period. The other is the compulsory conversion into equity at the end of the period which would result in the securing the company not to make future payments.

Conclusion

By looking at the above options, the best way for the company to go for the financing is the convertible debentures at the end of the finance period. The reason for that is as follows –

1. The company is in the difficulty stage in terms of finance and equity is concerned. The company it seems cannot go for the equity raising as this may dilute the management holding in the company resulting in risk of the management losing its control over the business.
2. The debentures are fixed cost finance documents which would result in small interest payment to the debenture holders and at the end of the finance period, the company can convert the debentures into shares and in the meantime make necessary adjustments in the equity so that the conversion do not result in diluting the shareholding pattern of the company.

Having said that, the company must ensure that it does not go for fresh equity at this point of time as this would result in some company taking over the business and the business has the risk of losing its separate existence at the its best. The company must not also raise capital from bank as the money would be at the higher side of interest rate and the banks loan would need to be repaid at the fixed time period. Also, this would result in securing the charge against the fixed assets of the company as so much high loan would not come without a fixed charge on the asset. The bank also imposes so many conditions on the loan disbursed by it.