ACCA AFM Syllabus A. Role Of The Senior Financial Adviser - Sources of Finance - Past Papers ^{4 / 9}

Conejo Co is a listed company based in Ardilla and uses the $ as its currency. The company was formed around 20 years ago and was initially involved in cybernetics, robotics and artificial intelligence within the information technology industry. At that time due to the risky ventures Conejo Co undertook, its cash flows and profits were very varied and unstable. Around 10 years ago, it started an information systems consultancy business and a business developing cyber security systems. Both these businesses have been successful and have been growing consistently.

This in turn has resulted in a stable growth in revenues, profits and cash flows. The company continues its research and product development in artificial intelligence and robotics, but this business unit has shrunk proportionally to the other two units.

Just under eight years ago, Conejo Co was successfully listed on Ardilla’s national stock exchange, offering 60% of its share capital to external equity holders, whilst the original founding members retained the remaining 40% of the equity capital. The company remains financed largely by equity capital and reserves, with only a small amount of debt capital.

Due to this, and its steadily growing sales revenue, profits and cash flows, it has attracted a credit rating of A from the credit rating agencies.

At a recent board of directors (BoD) meeting, the company’s chief financial officer (CFO) argued that it was time for Conejo Co to change its capital structure by undertaking a financial reconstruction, and be financed by higher levels of debt. As part of her explanation, the CFO said that Conejo Co is now better able to bear the increased risk resulting from higher levels of debt finance; would be better protected from predatory acquisition bids if it was financed by higher levels of debt; and could take advantage of the tax benefits offered by increased debt finance. She also suggested that the expected credit migration from a credit rating of A to a credit rating of BBB, if the financial reconstruction detailed below took place, would not weaken Conejo Co financially.

Financial reconstruction
The BoD decided to consider the financial reconstruction plan further before making a final decision. The financial reconstruction plan would involve raising $1,320 million ($1·32 billion) new debt finance consisting of bonds issued at their face value of $100. The bonds would be redeemed in five years’ time at their face value of $100 each. The funds raised from the issue of the new bonds would be used to implement one of the following two proposals:

(i) Proposal 1: Either buy back equity shares at their current share price, which would be cancelled after they have
been repurchased; or
(ii) Proposal 2: Invest in additional assets in new business ventures.

Conejo Co, Financial information
Extract from the forecast financial position for next year

Conejo Co’s forecast after-tax profit for next year is $350 million and its current share price is $11 per share.

The non-current liabilities consist solely of 5·2% coupon bonds with a face value of $100 each, which are redeemable at their face value in three years’ time. These bonds are currently trading at $107·80 per $100. The bond’s covenant stipulates that should Conejo Co’s borrowing increase, the coupon payable on these bonds will increase by 37 basis points.

Conejo Co pays tax at a rate of 15% per year and its after-tax return on the new investment is estimated at 12%.

Other financial information
Current government bond yield curve

The finance director wants to determine the percentage change in the value of Conejo Co’s current bonds, if the credit rating changes from A to BBB. Furthermore, she wants to determine the coupon rate at which the new bonds would need to be issued, based on the current yield curve and appropriate yield spreads given above.

Conejo Co’s chief executive officer (CEO) suggested that if Conejo Co paid back the capital and interest of the new bond in fixed annual repayments of capital and interest through the five-year life of the bond, then the risk associated with the extra debt finance would be largely mitigated. In this case, it was possible that credit migration, by credit rating companies, from A rating to BBB rating may not happen. He suggested that comparing the duration of the new bond based on the interest payable annually and the face value in five years’ time with the duration of the new bond where the borrowing is paid in fixed annual repayments of interest and capital could be used to demonstrate this risk mitigation.

Required:
(a) Discuss the possible reasons for the finance director’s suggestions that Conejo Co could benefit from higher levels of debt with respect to risk, from protection against acquisition bids, and from tax benefits. (7 marks)

Bournelorth Co is an IT company which was established by three friends ten years ago. It was listed on a local stock exchange for smaller companies nine months ago.

Bournelorth Co originally provided support to businesses in the financial services sector. It has been able to expand into other sectors over time due to the excellent services it has provided and the high quality staff whom its founders recruited. The founders have been happy with the level of profits which the IT services have generated. Over time they have increasingly left the supervision of the IT services in the hands of experienced managers and focused on developing diagnostic applications (apps). The founders have worked fairly independently of each other on development work. Each has a small team of staff and all three want their teams to work in an informal environment which they believe enhances creativity.

Two apps which Bournelorth Co developed were very successful and generated significant profits. The founders wanted the company to invest much more in developing diagnostic apps. Previously they had preferred to use internal funding, because they were worried that external finance providers would want a lot of information about how Bournelorth Co is performing. However, the amount of finance required meant that funding had to be obtained from external sources and they decided to seek a listing, as two of Bournelorth Co’s principal competitors had recently been successfully listed.

25% of Bournelorth Co’s equity shares were made available on the stock exchange for external investors, which was the minimum allowed by the rules of the exchange. The founders have continued to own the remaining 75% of Bournelorth Co’s equity share capital. Although the listing was fully subscribed, the price which new investors paid was lower than the directors had originally hoped.

The board now consists of the three founders, who are the executive directors, and two independent non-executive directors, who were appointed when the company was listed. The non-executive directors have expressed concerns about the lack of frequency of formal board meetings and the limited time spent by the executive directors overseeing the company’s activities, compared with the time they spend leading development work. The non-executive directors would also like Bournelorth Co’s external auditors to carry out a thorough review of its risk management and control systems.

The funds obtained from the listing have helped Bournelorth Co expand its development activities. Bournelorth Co’s competitors have recently launched some very successful diagnostic apps and its executive directors are now afraid that Bournelorth Co will fall behind its competitors unless there is further investment in development. However, they disagree about how this investment should be funded. One executive director believes that Bournelorth Co should consider selling off its IT support and consultancy services business. The second executive director favours a rights issue and the third executive director would prefer to seek debt finance. At present Bournelorth Co has low gearing and the director who is in favour of debt finance believes that there is too much uncertainty associated with obtaining further equity finance, as investors do not always act rationally.

Required:
(a) Discuss the factors which will determine whether the sources of finance suggested by the executive directors are used to finance further investment in diagnostic applications (apps). (8 marks)

Three proposals were put forward for further consideration after a meeting of the executive directors of Ennea Co to discuss the future investment and financing strategy of the business. Ennea Co is a listed company operating in the haulage and shipping industry.

Proposal 1
To increase the company’s level of debt by borrowing a further $20 million and use the funds raised to buy back share capital. 

Proposal 2
To increase the company’s level of debt by borrowing a further $20 million and use these funds to invest in additional non-current assets in the haulage strategic business unit. 

Proposal 3
To sell excess non-current haulage assets with a net book value of $25 million for $27 million and focus on offering more services to the shipping strategic business unit. This business unit will require no additional investment in non-current assets. All the funds raised from the sale of the non-current assets will be used to reduce the company’s debt.

Ennea Co financial information

Extracts from the forecast financial position for the coming year

Ennea Co’s forecast after tax profit for the coming year is expected to be $26 million and its current share price is$3•20 per share. The non-current liabilities consist solely of a 6% medium term loan redeemable within seven years.

The terms of the loan contract stipulates that an increase in borrowing will result in an increase in the coupon payable of 25 basis points on the total amount borrowed, while a reduction in borrowing will lower the coupon payable by  15 basis points on the total amount borrowed.

Ennea Co’s effective tax rate is 20%. The company’s estimated after tax rate of return on investment is expected to be 15% on any new investment. It is expected that any reduction in investment would suffer the same rate of return.

An alternative suggestion to proposal three was made where the non-current assets could be leased to other companies instead of being sold. The lease receipts would then be converted into an asset through securitisation.

The proceeds from the sale of the securitised lease receipts asset would be used to reduce the outstanding loan borrowings.

Required:

Explain what the securitisation process would involve and what would be the key barriers to Ennea Co undertaking the process. (5 marks)