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 companys growth since its inception in 1975. That growth, indicated of the activity in land development in the midAtlantic region of the United States, carried with it a persistent need for expansion capital. The companys 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 companys 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 HRIs 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 $6million funds. III. QUESTIONS

Does the proposed acquisition seems to fit HRIs businesss pattern? Why or why not? Ans.The proposed acqusition seem to fit HRIs 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 aacquisition 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 companys plan, from inception, had been deal in only the most potentially profitable land acquisition. Should the proposed acquisition be finan ced with debt,preferred stock,or common stock equity? What are the relevant decision criteria?
High Rock Industries Revenue Cost of sales Flotation cost Sinking cost Brokerage Fees EBIT Interest Taxable Income Old 10,000,000 5,589,300 Debt 10,600,000 5,589,300 200,000 400,000 5,292,840 2,795,000 2,497,840 Equity 10,882,140 5,589,300 Preferred Stock 11,272,140 5,589,300

4,410,700 2,375,000 2,035,700

5,292,840 2,375,000 2,917,840

390,000 5,292,840 2,375,000 2,917,840

Taxes 30% Profit after tax

610710 1,424,990

749352 1,748,488

875352 2,042,488

875352 2,042,488

High Rock Industries Balance Sheet :Equity Current Assets 7,500,000 Net Fixed Assets 52,000,000 Total Assets 59,500,000 Current Liabilities 500,000 Long term debt 25,000,000 Common stock 26,000,000 Retained earning 8,000,000 Total Liabilities and Equity 59,500,000 High Rock Industries Balance Sheet :Debt Current Assets 7,500,000 Net Fixed Assets 52,000,000 Total Assets 59,500,000 Current Liabilities 500,000 Long term debt 31,000,000 Common stock $20 Par 20,000,000 Retained earning 8,000,000 Total Liabilities and Equity 59,500,000 High Rock Industries Balance Sheet :Preferred Stock Current Assets 7,110,000 Net Fixed Assets 52,000,000 Total Assets 59,110,000 Current Liabilities 500,000 Long term debt 25,000,000 Common stock $20 Par 20,000,000 Preferred stock ($93.50) 5,610,000 Retained earning 8,000,000 Total Liabilities and Equity 59,110,000 Ratios Current Ratio Total Asset turnover Debt to Asset Ratio Return on Asset Ratio Return on Equity Ratio Time interest earned Ratio Debt to equity Ratio Debt 15 0.178151261 0.529411765 0.029386353 0.062446 1.893681574 1.125 Equity 15 0.18289311 0.42857143 0.03432753 0.06007318 2.22856421 0.75 Preferred Stock 14.22 0.19069768 0.43139909 0.03455402 0.15007259 2.22856421 0.91071429

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. What information and data are useful in answering Question 2? Ans. 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, yield on preferred stock, tax rate, current ratio, total asset turnover ratio, debt to asset ratio, return on asset ratio, time interest earned ratio and debt to equity ratio.The income statement and balance sheet data also supporting the calculation. Calculate HRIs debt to total asset ratio and the time interest earned ratio before and after new capital is acquired. Assume a 20% increase in current liabilities and a 20% increase in current assets. Discuss your findings? The calculation before and after the new capital is required through debenture showed in Table.

High Rock Industries Balance Sheet :Old Current Assets 1,500,000 1800000 Net Fixed Assets 52,000,000 52,000,000 Total Assets 53,500,000 53,800,000 Current Liabilities 500,000 600000 Long term debt 25,000,000 25,000,000 Common stock 20,000,000 Retained earning 8,000,000 Total Liabilities and Equity 53,500,000 High Rock Industries Balance Sheet :Equity Current Assets 7,500,000 9000000 Net Fixed Assets 52,000,000 52,000,000 Total Assets 59,500,000 61,000,000 Current Liabilities 500,000 600000 Long term debt 25,000,000 25,000,000 Common stock 26,000,000 Retained earning 8,000,000 Total Liabilities and Equity 59,500,000

High Rock Industries Balance Sheet :Debt Current Assets 7,500,000 9000000 Net Fixed Assets 52,000,000 52,000,000 Total Assets 59,500,000 61,000,000 Current Liabilities 500,000 600000 Long term debt 31,000,000 31,000,000 Common stock $20 Par 20,000,000 Retained earning 8,000,000 Total Liabilities and Equity 59,500,000 High Rock Industries Balance Sheet :Preferred Stock Current Assets 7,110,000 8532000 Net Fixed Assets 52,000,000 52,000,000 Total Assets 59,110,000 60,532,000 Current Liabilities 500,000 600000 Long term debt 25,000,000 25,000,000 Common stock $20 Par 20,000,000 Preferred stock ($93.50) 5,610,000 Retained earning 8,000,000 Total Liabilities and Equity 59,110,000 Ratio Old Debt Equity Preferred Stock Debt to asset 0.475836431 0.518032787 0.419672131 0.422916804 Time interest earned 1.85713684 1.89368157 2.22856421 2.22856421

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 ratio55%, so the company still has the capacity to increase its debt. What is the effect of sinking fund requirement upon your calculation in Question 2? Why might interest rate levels or company risk factor influence the imposition of a sinking fund? 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. 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 thats why the company unlikely use the sinking fund. What additional information would have been useful in your analysis of HRI? Explain The additional informations that would have been useful in HRI analysis are ddividend and growth for common stock to calculate return more accurately and precisely and Industry ratios. Consider your answers to Questions 2 and 3 above, then comment upon the meaning and usefulness of a probability estimate of the level of E BIT after the purchase? The estimate level of EBIT after purchase is useful in calculating new ROE and TIE. Probability estimate of the level of E BIT will be used to forecast the income and used to compare the benefit vs cost of alternatives.

Is there information, in addition to the specifics of the financing alternatives that should be provided by the investment banker? The investment bankers also should explain if additional debt will affect current HRI bond ratings.The investment bank with which HRI usually worked outline possibilites and condition for the acquisition of 6 million.The firm capital structure is different in commerical land development industry. If the stable developers such as HRI have a total debt to total asset ratio in the rang of 4855%, how much flexibilty for future financing will HRI have if debt is issued at present?

The current debt to asset ratio is 47.58% 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 51.80% 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 3%. If such flexibility, risk and income are major factpors in selecting a financing alternative, how should these conditions be defined and measured? The flexibility, risk and income can be considered and measured as below: Flexibility: The current debt to asset ratio is 47.58% 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 51.80% which still below the maximum limit. Measured by debt to asset ratio compare to industry limit. Risk (financial): The company meet debt service (interest and principal) especially when times are tough because the company TIE is high. Measured by TIE, cost of capital. Income: The Roe impact different financing alternative because preferred stock has high ROE. Measured by ROE . Flexibility, risk, and income are major factors in selecting a financing alternative. They can be measured through Debt to Asset ratio, TIE, cost of capital, and ROE. For HRI case, they can consider to use debt without sinking funds as their Debt Asset 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. In future, company has to solved its debt or consider raised equity to get additional funds needed.