Advanced financial management revision question and answer

Juma Company Ltd. Which is effectively controlled the Juma family although they own only a minority of shares, is to undertake a substantial new project which requires external finance of about Sh.400 million, leading to a 40% increase in gross assets. The project is to develop and market a new product and is fairly risky. About 70% of the funds required will be spent on land and buildings. The resale value of the land and buildings is expected to remain equal to or greater than, the initial purchase price. Expenditure during the development period of the first 4 to 7 years will be financed from other revenue of Juma Company Ltd. This will have a consequent strain on the company‟s overall liquidity.

If, after the development stage, the project proves unsuccessful, then the project will be terminated and its assets sold. If, as is likely, the development is successful, the project‟s assets will be utilised in production and the company‟s profits will rise considerably. However, if the project proves to be very successful, thenadditional finance may be required to further expand the production facilities.

At present, Juma Company Ltd. Is all equity financed.

The financial manager is uncertain whether he should seek funds from a financial institution in the form of an equity interest, a loan (long or short term) r convertible debentures.

(a) Describe the major factors to be considered Juma Company Ltd. In deciding on the method of financing the proposed expansion project.

(b) Briefly discuss the suitability of equity, loans and convertible debentures for the purpose of financing the project from the point of view of:
(i) Juma Company Ltd.
(ii) The provider of finance.

Clearly state and justify the type of finance recommended for Juma Company Ltd.

(c) Butere Sugar Company Ltd. Has been enjoying a substantial net cash inflow. Before the surplus funds are needed to meet tax and dividend payments, and to finance further capital expenditure in several months time, they are invested in a small portfolio of short-term equity investments.
Details of the portfolio, which consist of shares of four companies listed on the stock exchange are as follows:

The current market return is 19% a year and treasury bill yield is 11% a year. Required:
On the basis of the data given above, calculate the risk of Butere Sugar Company Ltd.‟s short-terminvestment portfolio relative to that of the market.

(a) The following are among the major factors to be considered Juma in deciding on the method of financing the proposed expansion project.

(i) Liquidity during the development period
Ideally the finance selected should minimize the drain on cash flows during the development period.

(ii) Terms of finance
Finance is required for at least 4 – 7 years hence short term loans which will require re- financing are not suitable. However, long term or permanent finance may produce an excess of funds after the development period if the project proves to be unsuccessful.

(iii) Risk
Debt with contractual interest and repayment, patterns may prove risky for Juma‟s cash management activities. Equity, without any contractual dividend requirements, may prove to be the finance source with lowest risk for Juma‟s management.

(iv) Debt capacity
There may be goods for issuing debt, thereutilizing some unused debt capacity and taking advantage of the tax deductibility of debt interest.

(v) Possibility of further finance required
It is possible that further finance will be required after the development period. Hence financing decisions should be taken in a dynamic context whereconsideration is given to possible further finance requirements.

(vi) Dilution
An increase in equity issuing shares to new shareholders will reduce the control and possibly, depending upon the issue price and quantity of shares issued, the wealth of existing shareholders.

(vii) Use of funds raised
Funds should be raised only if their use appears to be productive. Points concerning the suitability of the three finance types include:
(b) From Juma‟s viewpoint
(i) Equity
Extremely suitable from the liquidity aspects as dividends need not be paid.

If the project is not successful then permanent funds will result. However, if the project is extremely successful the greater equity base will provide even further debt capacity to facilitate further expansion. Would dilute the holdings of current shareholders.

(ii) Loans
Would utilize some unused debt capacity. Interest payments would be required under all circumstance but would be tax deductible. Term of the loan may be difficult to arrange in order to provide the medium term (up to 4 – 7 years) or long term finance.

(iii) Convertible debentures
Have the advantage that investment payments are tax deductible but are usually lower than the interest rate on ordinary loans thereconserving them the debt will be converted into equity and could then provide the equity base for further debt financing expansion.

If the project is not successful then conversion will not take place and the debenture can be repaid. Conversion into equity will usually result in fewer new shares being issued with consequent less dilution.

From the finance provider‟s viewpoint

(i) Equity
Enables participation in the success of the firm but provides no security in the event of the project not providing successful.

(ii) Loans
Provide security and regular interest payments but will not permit participation in any success of the firm.

(iii) Convertible debentures
Provide the security of a loan with the possibility of favourable (but not unfavourable) equity participation. However, in order to obtain this protected position the interest received is usually lower than a normal loan and the conversion terms result in fewer shares than would be obtained an initial investment in equity.

In the circumstances of Juma, the use of convertible debentures is recommended as they will utilize d ebt capacity and provide medium term or long term finance as required the outcome of the project.

The debentures should be convertible into equity from about year 4 onwards at the holder‟soption unless previously repaid Juma. Juma should arrange a repayment option during the period of about years 4 – 7. The debentures could be secured on the land and buildings to be purchased.

(c) The risk of the portfolio can be measured the weighted average beta factor for the shares in the portfolio. The weights should be the market prices of the shares.

Since the beta factor is over 1, we can conclude that the risk of the portfolio is higher than the risk of the market as a whole.

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