HIGH ROCK INDUSTRY

The Debt versus Equity Financing Alternative

I. INTRODUCTION

High Rock Industries is a company which engaged in the purchase of undeveloped acreage which

was then developed for industrial use. Over the past fifteen years, the company had become the

dominant mid-Atlantic developer of office parks. Kathleen Crawford is the president and CEI of Hugh

Rock Industries, reflected upon the company’s growth since its inception in 1975. That growth, indicated

of the activity in land development in the mid-Atlantic region of the United States, carried with it a

persistent need for expansion capital. The company’s plan, from inception, had been deal in only the

most potentially profitable land acquisition.

Crawford was intent upon having the infrastructure necessary to make he company’s strategy

work, thus having the best people on staff was the key element. The staff had not only well-qualified

accountants and marketing people, but appraisers and specialized analysts who addresed leasing, zoning

requirements, and population patterns. As a result, strategy had always been defined in terms of specific

competencies, which led to clearly defined products and markets.

The revenue and profits of HRI increased at a steady pace, which means it provides access to

higher-priced, and hopefully, better situated property, hence faster profit growth. The debentures

currently outstanding with coupon rate 9.5% and carry AAA rating. Most typical firms with similar bond

rating has maximum 55% in their capital structure.

Kathleen Crawford was interested to a tract of land in the general vicinity of Washington DC. The

land was to the west of the DC metro area along the border shared by Maryland and Virginia. The

development in that area was primarily commercial and had become the site of some very-well situated

office parks and federal office buildings. The area was occupied by several US offices of foreign

governments and business. HRI considered the asking price of $6million to be most reasonable and they

forecasted buying this land will increase HRI EBIT to 20%. The forecast was based upon the occupancy

rate of commercial property in the immediate area, a forecast of commercial construction, and HRI’s

skill in managing such property. To acquire the land, HRI should raise the funds, and as alternatives are:

Debt: 7% coupon, 15 years maturity, flotation cost $200,000, possibility of sinking fund $400,000

Equity : Market price $ 30

Preferred stock : $100 preferred stock with net price $93.5 after brokerage fees, with stock yield 8%

II. MAIN ISSUE

HRI has to choose which alternative is best to the company to raise the S6million funds.

III. QUESTIONS

1. The proposed acqusition seem to fit HRI’s business pattern as HRI is engaged in the purchase of

undeveloped acreage which was then developed for industrial use, especially in office parks. The

acquisition proposal land located in urban areas that has a good development in commercial and had

become the site of some very-well situated office parks and federal office buildings. The acquisition

considered as a profitable project by the assessment of her high skill financial staff as it will increase

the EBIT to 20% which in line with the company’s plan, from inception, had been deal in only the

most potentially profitable land acquisition.

2. There are several criterias to analyse the financial decision, in this case, we will highlighted more to

flexibility, risk, and income. YOU DON’T HAVE to calculate

(Spreadsheet is attached as Table 1)

The cost of capital was calculated as below:

a. Debt (ignoring the sinking fund)

Calculated with Excel, for N=15; Icoupon=7%; FV=$6,000,000; PV=$5,800,000;PMT=$420,000,

found that rd = 7.37%, hence cost of debt after tax = 7.37%(1-30%) = 5.16%

b. Debt (with sinking fund)

Calculated with Excel, for N=15; Icoupon=7%; FV=$6,000,000; PV=$5,800,000;PMT=$820,000,

found that rd = 11.3%, hence cost of debt after tax = 11.3%(1-30%) = 7.91%

c. Equity

Calculated by ROE = rs= Net income / Common equity = $2,042,488/ $34,000,000 = 6.01%

d. Preferred stock

Known as dividend yield = rps = 8%

Based on debt to asset ratio, common stock and preferred stock alternatives has lower value

compare to debt alternatives, however the value for debt alternatives was still within range (less

than 55%). Same thing goes for TIE, common stock and preferred stock alternatives has higher value

compare to debt alternatives. But, based on cost of capital, debt without sinking funds has the less

cost of capital, and based on ROE, debt has the highest ROE among all alternatives. Thus, the

reccomendation will goes to debt without sinking funds.

3. All informations that stated in debt alternatives are useful. Besides that, the other useful information

is net income and total common equity because they are used to calculate ROE and also yield on

preferred stock and the tax rate. The income statement and balance sheet data also supporting the

calculation.

4. The calculation before and after the new capital is required through debenture, can be showed in

Table 2.

(Spreadsheet is attached)

Our findings are that through the additional debt, it will increase the debt ratio but it also increases

the TIE ratio. Although debt ratio increases but it still below the industry ratio, so the company still

has the capacity to increase its debt.

5. A sinking fund is a method by which an organization sets aside money over time to retire its

indebtedness. More specifically, it is a fund into which money can be deposited, so that over time its

preferred stock, debentures or stocks can be retired. For the organization retiring debt, it has the

benefit that the principal of the debt or at least part of it, will be available when due. For the

creditors, the fund reduces the risk the organization will default when the principal is due: it reduces

credit risk. However, if the bonds are callable, this comes at a cost to creditors, because the

organization has an option on the bonds: the firm will choose to buy back discount bonds (selling

below par) at their market price, while exercising its option to buy back premium bonds (selling

above par) at par.

As seen in Table 1, the sinking funds will add aditional expense to firms and will increase the cost of

debt. Thus, it will effect in decision. If the company is risky, then investor required higher return so

company can consider of using sinking fund in secure their debt holder position. But in this case, the

company bond rating is triple A which is considered as less risky company, supported with HRI

reputation within the financial community, so that’s why the company unlikely use the sinking fund.

without

PV = 6,000 – 200

F = 6,000

PMT = 7% * 6,000 = 420

with

PMT = 420

PMT2 = 7% * 5600 - JUST LIKE AMORTIZATION !

IT’S NOT GONNA BE THE SAME FOR EACH YEAR!

6. The additional informations that would have been useful in HRI analysis are dividend and growth for

common stock to calculate rs more accurately and precisely. Industry comparable ratios..

7. The estimate level of EBIT after purchase is useful in calculating new ROE and TIE.

8. As addition with Answer for Question number 3, the investment bankers also should explain if

additional debt will affect current HRI bond ratings.

9. The current debt to asset ratio is 47.66% before the debt is acquired. As HRI want to mantain the

debt to asset ratio in range 48-55%, HRI only can have space for increasing debt up to 7% from

current. But however, additional $6million in debt will add to 53,02% which still below the maximum

limit. If after this company still have plan to issue long term debt, the company only has the capacity

to increase its debt not more than 2%. Low flexibility..!!! because its already closed to the maximum

ratio.

10.The flexibility, risk and income can be considered and measured as below:

Flexibility: Does increasing debt restrict the firm for seeking more debt in the future due to high debt

levels? Does increasing debt violate loan covenants or result in the potential for loan covenants to

be violated with poor performance?

Measured by debt to asset ratio compare to industry limit.

Risk (financial): Can the company meet debt service (interest and principal) especially when times

are tough? How volatile are the company’s earnings and cash flow?

Measured by TIE, cost of capital.

Income: How do the different financing alternatives impact earnings per share (EPS) and return on

equity (ROE)?

Measured by ROE and EPS. But we can’t count the EPS since there is no price…

FRICTO!! THEORIES

IV. CONCLUSION AND RECOMMENDATION

Flexibility, risk, and income are major factors in selecting a financing alternative. They can be

measured through D/A ratio, TIE, cost of capital, and ROE. For HRI case, they can consider to use debt

without sinking funds as their D/A ratio and TIE were still in industry limit, and ROE has the highest value

among all alternatives, meanwhile the cost of capital is lowest compare to others. HRI can consider to

ignore sinking funds regarding to its existing level of interest rates and its reputation within the financial

community. Company might give expected dividend and growth to calculated cost of equity more

precisely. In future, company has to solved its debt or consider raised equity to get additional funds

needed.