PREFERRED STOCK ISSUANCE-BRUKVEILL-DEBT-VS-EQUITY

Case Analysis

Group 2Ambokar Nimish | Anurag Gupta | Ashwin Mathew Philipose | Avinash Murali

Nair |B Ushashree | Baidyanath Bose | Balakrishnan M

The Organization

Electricity utility company providing electricity to industry and consumers 

Serves majorly n areas of rural community concentrating the border areas of two adjoining states in the Midwest

Morgan and Bill Frederick, the corporate controller managed the company’s financial staff

Company was financial sound and agile Forecasted with good growth opportunities

Issues at hand

Debate over long-term funds revolved around the type of security (Common stock, preferred stock and debt) to use in the acquisition of the funds

Funds required for an overdue replacement of several of its substations and several other expansion and replacement projects

Several aspects of preferred stocks to be considered for financing Determine whether preferred stock issuance was in the best interest

of BPL and its customers

Question1:Calculate the ROE and total debt/total assets ratios for BPL for 1992.Solution:-  ROE of the company = Net Margin/Total Equity = 3881/33859 = 11.46% Total Debt to Asset Ratio = Total Debt/Total Asset

= (8713 + 75623)/120180 = 70.17%

Question 2:What is the feasibility of debt or common stock issuance for BPL?Solution:-  Feasibility of a Debt

Company D/A ratio > Industry D/A ratio consequently the company is more riskier. so, it should not go for more debt.

Cost of Debt will be high for the company, interest rate on corporate bonds are high

DEBT TO ASSET RATIOIndustry Debt to asset ratio 24%

Company Debt to asset ratio 70.17%

Conti….  Feasibility of a Common Stock Issuance –

Industry ROE = 11%, Company ROE = 11.14 % ROE of the company and the industry are almost same, which signifies that

if company goes for issuing more common stock then it may lead to lower ROE, which in turn lead to lower EPS

Market for common stock was in a depressed state Dilute the ownership and control of the existing shareholders Common stock dividends are not tax deductible payments

Question3:If long-term funds must be acquired at this time, is preferred stock a feasible alternative? If the $50 preferred stock of the similar utility is a perpetuity, and BPL’s issue will also be a perpetuity, what is the yield on each issue of stock?Solution:-

Preferred stock dividends are paid at the discretion of the company, so preferred stock dividends could be deferred in times of financial distress

Longer-term maturities with fixed yields provide a hedge against deflationary environments

Company has already loaded their balance sheet with a large amount of debt and risk a downgrade if they piled on more

Preferred dividends are not tax-deductible In case of falling rate environment, company can benefit from call option of

converting preferred stock to common equity Yield of the preferred stock:- Annual Dividend per share/ Price per share of

preferred stock = 6/100 = 6%

Question4:Is preferred stock a fund-raising mechanism used only by utilities?Solutions :-

Bank holding companies treats certain types of preferred stocks (what are called hybrid preferred stocks) as Tier 1 capital (a key measure of a bank's financial strength) for capital adequacy purposes

In addition to utility, any companies with weaker credit ratings can issue preferred stock irrespective of the industry

Question5:List some important characteristics of preferred stock. Why are these characteristics important? If the BPL issue is cumulative, what are the implications for voting rights of the preferred stock holders?Solution:- Characteristics of Preference Stock

Participating Preference Shares - Participating preference shareholder receives stipulated dividend and shares additional earnings with the common shareholders. But this share is usually non-cumulative

Cumulative Preference Share - Cumulative provisions accumulates if dividend not paid by the company. Normally, the firm must pay these unpaid dividends prior to the payment of dividends on the common stock.

Non-Cumulative Preference Share – Cumulative provision do not accumulates in case of default by the company

Voting Rights - Preference shares do not normally confer voting rights except in certain special circumstances which will discussed in coming slides

Conti.… Par Value-

No-par value stock is issued by the company without specifying the par value in the prospectus Most preference shares have a par value. When it does, the dividend rights and call price are usually stated in terms of the par value. However, those rights would be specified even if there were no par value

Redeemable or Callable Preference Shares– Non-callable preference shares and bonds are issued in periods of high interest rates Preference shares have no maturity date Redeemable or callable preference shares may be retired by the issuing company upon the payment of a definite price stated in the investment. call price” provides for the payment of a premium, the provision is more advantageous to the corporation than to the investor

Conti…. Sinking Fund Retirement-

Preference share issue is often retired through sinking funds. In these cases, a certain percentage of earnings (above minimum amounts) are allocated for redemption each year Sinking Fund have favourable overtones for the owners of shares as dividend payment become more certain

Preemptive Right- Depending on Common law statute , preference shareholders gets the right to subscribe to additional issues to maintain their proportionate share of ownership

Conti…. Implications for voting rights of the preferred stock holders if the

BPL issue is cumulative The cumulative preference shares can vote if their dividend is in arrears

for 2 years. The voting right of each preference shareholder is to be in the proportion which the paid-up share capital on his shares bears to the total equity share capital of the company.

In India, for instance, the non- cumulative type qualifies for voting rights if preference dividends have been in arrears for the two financial years preceding the meeting or for any three years during a period of six years (ending with the financial year) preceding the meeting.

Question6:What is the long-term effect upon financial structure of a preferred issue convertible to common stock? What is the purpose of the convertible feature?Solutions:- Long Term Effect

When financial analysts, investors or corporate managers evaluate a company’s performance, they take potential dilution of EPS into account

Holders of convertible preferred stock can exchange their shares for a specified number of newly minted common shares

Corporations can take various "anti-dilution" measures when issuing convertible securities to lessen the probability or impact of dilution

Convertible preferred stock is dilutive since conversion increases the number of common shares, thereby reducing the ownership level and EPS of each

Conti…. Why convertibles? Or the purpose of convertibles

With convertible preferred, a company can secure a lower interest rate than with pure debt financing and use the promise of a dividend to sell shares at a higher price

Issuing convertible preferred is a way for companies to raise capital on better terms than they could with traditional equity financing, especially if they have low stock prices already (new equity would dilute shareholders considerably) or if they have poor credit and cannot borrow at reasonable rates

Companies with poor credit sometimes use preferred shares to gain revenue, the risk of default may be slightly higher

Delayed dilution of common stock and earnings per share (EPS)

Different investors have different risk-return tradeoff preferences and issuing preference share to appeal to the broadest possible market

Question7:Comment upon the relative debt burden of BPL compared to the industry data given in Table 4. Comment further upon the ability of utilities to carry fixed-income obligationsSolution:- Relative Debt Burden of BPL compared to the industry

Industry Debt to asset ratio = 24%, Company Debt to asset ratio = 70.17%

Company D/A ratio > Industry D/A ratio implying that company is more leveraged and riskier. So, it should not go for more debt

Ability of utilities to carry fixed-income obligations Interest Coverage Ratio = EBIT/Interest Expense = 5900 / 4219 = 1.39 Ability to pay debt expense is questionable as ICR is very low Curtailment of industrial demand will lead to less income in future, which

in turn would decrease ICR further

Question8:Discuss alternatives to a preferred stock issue for the companySolution:- Alternatives to a preferred stock issue for the company are debt

financing and common stock issueDebt Financing

Interest rate on corporate bonds are high, so Cost of Debt will be high for the company

Company’s debt to total assets ratio was at a level beyond which the financial staff believed a downgrading of the company’s bond rating would be possible

ICR is very low so company should not go for debt financing

Conti….Common stock issue

Process of raising capital through the sale of common share ROE of the company and the industry are almost same, which signifies

that if company goes for issuing more common stock then it may lead to lower ROE, which in turn lead to lower EPS.

Market for common stock was in a depressed state. As measured by the usual indices, the market was at a two-year low

Dilute the ownership and control of the existing shareholders

Question9:Discuss the feasibility of a long-term debt issuance convertible to common stock.Solution:- Feasibility of a long-term debt issuance convertible to common stock

Lower fixed-rate borrowing costs- Convertible bonds allow issuers to issue debt at a lower cost. Typically, a convertible bond at issue yields 1% to 3% less than straight bonds. This would help in decreasing Interest Expense and maintaining ICR which is favorable for the company.

Higher conversion price than a rights issue strike price– Company can fix conversion price for a convertible bond higher than the level that the share price ever reached, which would help in the gaining higher premium

Voting dilution deferred- With a convertible bond, dilution of the voting rights of existing shareholders only happens on eventual conversion of the bond

Question10:What is the likelihood of a preferred stock issue being well-received by investors?Solution:-

From the shareholders' perspective preferred stock enjoys a higher claims to the issuer's earnings and assets than common stock

Preferred stock dividends must be paid prior to common stock dividends Preference shareholders’ may perceive it as the move is to avoid dilution

of the control for more efficient functioning of the company On the other hand, investors may wonder why BPL would issue preferred

stock paying a generous dividend when they could presumably issue debt securities with more favorable tax consequences

Investors may also not be confident of receiving regular dividend in the future due to contraction in demand leading to lower earnings

Question11:What is the role of the financial intermediary in BPL’s capital needs situation?

Solution:-Financial Intermediary help BPL in arranging financing through following options available to them:

Private Equity - Private equity are the firms that provide funding to companies that are mature in their life cycle and BPL is one of them

Loan Syndication- It is kind of debt financing where banks can arrange funds from a group of banks called syndicate and this process is called loan syndication

Issue Management- This comes under equity financing, investment bank will facilitate the process of raising money from the public through issuing shares for the public. Both common stocks and preferred stocks would come under this domain

.

Question12:Discuss the fact that BPL is a regulated industry? What effect does this have upon their financing plans?Solution:- BPL- Regulated Industry BPL is a utility industry regulated as per the rules of law. It is seen from the case itself that  company’s debt to total assets ratio was at a level beyond which the financial staff believed a downgrading of the company’s bond rating would be possible.There are various regulations for a utility industry : Power Purchase Agreements (PPA) Federal Energy Regulatory Commission (FERC)As the utility industry evolves, as markets grow more volatile and as regulations change, investors can expect more lucrative opportunities. Simultaneously, they must learn to embrace more risk. 

Conti…. Effect on financing planning

As the utility industry evolves, as markets grow more volatile and as regulations change, it is very difficult for the company to comply PPA agreement.

Investors also expects more lucrative opportunities with the evolving utility industry

Investors ought to keep an eye on debt levels. High debt puts a strain on credit ratings, weakening new power generators' ability to finance capital expenditure. Poor credit ratings make it awfully difficult for traders to purchase energy contracts on the open market