2. Tippletine Co is based in Valliland. It is listed on Valliland’s stock exchange but only has a small number of shareholders. Its directors collectively own 45% of the equity share capital.

Tippletine Co’s growth has been based on the manufacture of household electrical goods. However, the directors have taken a strategic decision to diversify operations and to make a major investment in facilities for the manufacture of office equipment.

Details of investment
The new investment is being appraised over a four-year time horizon. Revenues from the new investment are uncertain and Tippletine Co’s finance director has prepared what she regards as cautious forecasts.

She predicts that it will generate $2 million operating cash flows before marketing costs in Year 1 and $14·5 million operating cash flows before marketing costs in Year 2, with operating cash flows rising by the expected levels of inflation in Years 3 and 4.

Marketing costs are predicted to be $9 million in Year 1 and $2 million in each of Years 2 to 4.

The new investment will require immediate expenditure on facilities of $30·6 million. Tax allowable depreciation will be available on the new investment at an annual rate of 25% reducing balance basis.

It can be assumed that there will either be a balancing allowance or charge in the final year of the appraisal. The finance director believes the facilities will remain viable after four years, and therefore a realisable value of $13·5 million can be assumed at the end of the appraisal period.

The new facilities will also require an immediate initial investment in working capital of $3 million. Working capital requirements will increase by the rate of inflation for the next three years and any working capital at the start of Year 4 will be assumed to be released at the end of the appraisal period.

Tippletine Co pays tax at an annual rate of 30%. Tax is payable with a year’s time delay. Any tax losses on the
investment can be assumed to be carried forward and written off against future profits from the investment.

Predicted inflation rates are as follows:

Financing the investment
Tippletine Co has been considering two choices for financing all of the $30·6 million needed for the initial investment in the facilities:

– A subsidised loan from a government loan scheme, with the loan repayable at the end of the four years. Issue costs of 4% of the gross finance would be payable. Interest would be payable at a rate of 30 basis points below the risk free rate of 2·5%.

In order to obtain the benefits of the loan scheme, Tippletine Co would have to fulfil various conditions, including locating the facilities in a remote part of Valliland where unemployment is high.

– Convertible loan notes, with the subscribers for the notes including some of Tippletine Co’s directors. The loan notes would have issue costs of 4% of the gross finance.

If not converted, the loan notes would be redeemed in six years’ time. Interest would be payable at 5%, which is Tippletine Co’s normal cost of borrowing. Conversion would take place at an effective price of $2·75 per share.

However, the loan note holders could enforce redemption at any time from the start of Year 3 if Tippletine Co’s share price fell below $1·50 per share. Tippletine Co’s current share price is $2·20 per share.

Issue costs for the subsidised loan and convertible loan notes would be paid out of available cash reserves. Issue costs are not allowable as a tax-deductible expense.

In initial discussions, the majority of the board favoured using the subsidised loan. The appraisal of the investment should be prepared on the basis that this method of finance will be used.

However, the chairman argued strongly in favour of the convertible loan notes, as, in his view, operating costs will be lower if Tippletine Co does not have to fulfil the conditions laid down by the government of Valliland.

Tippletine Co’s finance director is sceptical, however, about whether the other shareholders would approve the issue of convertible loan notes on the terms suggested. The directors will decide which method of finance to use at the next board meeting.

Other information
Humabuz Co is a large manufacturer of office equipment in Valliland. Humabuz Co’s geared cost of equity is estimated to be 10·5% and its pre-tax cost of debt to be 5·4%.

These estimates are based on a capital structure comprising $225 million 6% irredeemable bonds, trading at $107 per $100, and 125 million $1 equity shares, trading at $3·20 per share. Humabuz Co also pays tax at an annual rate of 30% on its taxable profits.

Required:

(b) Discuss the issues which Tippletine Co’s shareholders who are not directors would consider if its directorsdecided that the new investment should be financed by the issue of convertible loan notes on the terms suggested.

Note: You are not required to carry out any calculations when answering part (b). (8 marks)