The Rondo Company: Evaluation of Financing Options

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Memorandum on the Financing Options

This memorandum evaluates the different long-term financing options available to the company for the new project to manufacture new types of pipes as well as for future expansion needs of the Company.

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Normally the guiding principle for deciding on the debt/equity mix is the maximization of the firm value in terms of the value of its stock. It is for the financial managers to arrive at a proper debt/equity mix and this decision is primarily affected by the funding needs of the firm in the context of the uncertainty of the future earnings of the firm. It also depends on the accessibility of the capital market by the firm. The financial manager has also to ensure that the shareholder value is maximized by borrowing at the lowest cost of capital. Thus the choice of the firm’s optimum financing mix is “based on a tradeoff between the benefits and costs of choosing debt versus equity.” (Business.UUC)

In the matter of financing the capital expenditure projects the firms are always confronted with the decision to choose from paying large dividends with the retention of lower profits leading to heavy external financing for future investments or to pay retain higher profits by paying lower dividend so that they need to resort to lower external financing for the future investments. Hence the dividend policy of a firm decided the debt/equity mix of the company’s capital structure.

Characteristics and Costs of Various Debt and Equity Instruments

The equity form of financing the long term needs of a firm involves the issue of different kinds of stocks. The equity form of investment allows the firm to reduce personal risks of the owners. Even in case the business fails, the firm has to repay the debts being the borrowings by the company or the firm has to get the loans reorganized the debt repayment under bankruptcy protection. The cost of financing through equity is the dividend that the firm has to pay to the investors. Equity is considered more expensive than debt as the equity investor usually undertakes more risk and hence expects more return on the investments. Thus the cost of financing with equity is usually significantly higher than financing with debt.

Another type of equity is represented by the preferred stock. The dividends are payable are in preference to the payment of dividends on the common stock. “The amount of dividends that will be paid to the holders of preferred shares may be stated as a percent of its par value, or as a flat dollar amount.” (Business Reference)

Debentures and bonds represent some of the debt instruments. In contrast to the equity form of financing debt instruments do not provide any ownership rights to the bondholders. The cost of long term debt is the after-tax cost of borrowing through the issuance of bonds. The proceeds of the bonds are reduced by the costs incurred to issue and sell the securities which are known as flotation costs. It is important to state the cost of financing on an after-tax basis. This is so because the interest payable on debt financing is tax-deductible.

Long Term Financing Alternatives

There are different alternatives available for funding the long term financing needs of the firm. The firm may decide to finance its long term needs through various alternative forms like equity, bonds or leasing.

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Equity

Equity represents the fundamental ownership units of the corporation. The firm may resort to equity in the form of common stock or preferred stock. The common stocks provide ownership to the stockholders. Usually certain voting rights are attached to the common stock. The option of using equity as long term financing alternative allows the firm to sell its shares to the investors who provides the necessary funds for financing the long term capital investment needs of the company. By using the equity form of financing the firm can use the funds accumulated through the issue of equity to grow the business instead of spending the cash on payment of interest and repayment of the loan.

Bonds

A bond represents a debt security. The issuer of the bond becomes the debtor for the bond holder and the bond issuer is obligated to make the repayment of the principal and interest borrowed on an agreed future date. The bond should be considered as a loan covered with security. The issuer of the bond is the borrower and the bond holder is the lender. By issuing the bonds the firm should be able to finance the long-term investment with the funds from external sources. Although both bonds and stocks are considered as securities the bond holders are lenders to the issuing company but the stockholders represent the owners of the firm. Changes in some of the associated factors will influence the value of the bonds as and when such changes occur during the currency of the bonds. Since the yield and the price of a bond have an inverse relationship the changes in the market interest rates affect the bond prices.

The various financing options for Rondos are presented in the following table:

Options Amount of Finance Number of Years Rate of Interest/Dividend Total Cash Outflow Present Value
Common Stock $ 15,00,000
Common Stock $ 5,000,000
Mortgage Bond $ 8,000,000 10 9.00% $ 11,960,000 $ 7,806,455
Mortgage Bond $ 13,000,000 10 9.00% $ 16,960,000 $ 10,929,539
Convertible Bond $ 10,000,000 10 8.63% $ 18,630,000 $ 9,031,372
Preferred Stock $ 8,000,000 15 9.38% $ 18,155,200 $ 7,554,975
Preferred Stock $ 13,000,000 15 9.38% $ 29,502,200 $ 12,276,835
Bank Loan $ 10,000,000 6 11.5% $ 14,600,000 $ 10,589,425

In the case of common stocks with the issue of $ 15,000,000 million worth stocks, there is a higher level of dilution at 22% and more dividend payments to the new equity holders as the management is keen on maintaining the current rate of dividend. Therefore the Company can consider issuing a lower level of common equity.

In the case of mortgage debentures of $ 8,000,000 the cost of debt is only 9% which is less than the Weighted Average Cost of Capital of the company (WACC) which is calculated at 9.62%. The interest on mortgage debentures can also be charged off against profits for taxation purposes. However with a higher mortgage bond of $ 13,000,000 the company will become more geared and hence it is suggested to keep a lower level of debt.

In the case of convertible bonds though the cost of funds is low at 8.63% and the present value as is comparatively lower, there is the potential risk of the bond holders exercising their option when there are changes in the market conditions. Similarly issuing the preferred stock also is undesirable from the point of view of cost and dilution of ownership.

Considering all the issues discussed, it is recommended that the company issues common equity of $ 5,000,000 and obtain debt fund through the issue of mortgage bonds to the extent of

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$ 8,000,000 to meet its acquisition of Poly Pipe and to meet the financial needs of the expansion plans. This way the company can maintain its gearing ratio as well as get the tax advantage from the interest payments on the mortgage bonds.

References

Business Reference ‘Cost of Capital’. Web.

Business UUC ‘The Firm’s Financial Policy’. Web.

Appendix

COMMON STOCK
Price of Share $62 $62
Flotation $9 $9
Net Per Share to Equity $53 $53
Current Shares Outstanding 1,000,000 1,000,000
Financing Needed $ 15,000,000 $ 5,000,000
Current Shares Outstanding 1,000,000 1,000,000
Required Shares 283,019 94,340
New Share Total 1,283,019 1,094,340
Dilution
New Shares/ Total Shares 22% 9%
Cost of Common Stock
Flotation Cost/ Stock Price 15% 15%
Existing shares as % of total 78% 91%
common stock after issue of
new shares
MORTGAGE BOND
Without Poly Pipe Purchase
9.00% 9.62%
Balance of Principal Interest Cash PV
Year Debt Payment Payment Outlay of cash outlay
1 2005 8,000,000 800,000 720,000 1,520,000 1,386,608
2 2006 7,200,000 800,000 648,000 1,448,000 1,205,005
3 2007 6,400,000 800,000 576,000 1,376,000 1,044,598
4 2008 5,600,000 800,000 504,000 1,304,000 903,064
5 2009 4,800,000 800,000 432,000 1,232,000 778,326
6 2010 4,000,000 800,000 360,000 1,160,000 668,527
7 2011 3,200,000 800,000 288,000 1,088,000 572,006
8 2012 2,400,000 800,000 216,000 1,016,000 487,276
9 2013 1,600,000 800,000 144,000 944,000 413,013
10 2014 800,000 800,000 72,000 872,000 348,031
2015 0
3,960,000 11,960,000 7,806,455
Stated value/stated amount of interest is 9.00%
researched value of similar debt is 9.62% (WACC)
Repayment of principal 10%
With Poly Pipe Purchase
9.00% 9.62%
Balance of Principal Interest Cash PV
Year Debt Payment Payment Outlay of cash outlay
1 2005 13,000,000 1,300,000 720,000 2,020,000 1,842,729
2 2006 12,200,000 1,300,000 648,000 1,948,000 1,621,098
3 2007 11,400,000 1,300,000 576,000 1,876,000 1,424,175
4 2008 10,600,000 1,300,000 504,000 1,804,000 1,249,330
5 2009 9,800,000 1,300,000 432,000 1,732,000 1,094,206
6 2010 9,000,000 1,300,000 360,000 1,660,000 956,686
7 2011 8,200,000 1,300,000 288,000 1,588,000 834,876
8 2012 7,400,000 1,300,000 216,000 1,516,000 727,078
9 2013 6,600,000 1,300,000 144,000 1,444,000 631,770
10 2014 5,800,000 1,300,000 72,000 1,372,000 547,591
2015 0
13,000,000 3,960,000 16,960,000 10,929,539
Stated value/stated amount of interest is 9.00%
researched value of similar debt is 9.62% (WACC)
Repayment of principal 10%
CONVERTIBLE BONDS
Conversion Price 64
Market Price 62
Conversion Premium 2
Amount of Bonds $ 10,000,000
Face Value $1,000
No of Bonds 10000
Conversion Premium $ 20,000
PV of Interest Calculations
8.63% 9.62%
Balance of Principal Interest Cash PV
Year Debt Payment Payment Outlay of cash outlay
1 2005 10,000,000 863,000 863,000 787,265
2 2006 10,000,000 863,000 863,000 718,177
3 2007 10,000,000 863,000 863,000 655,151
4 2008 10,000,000 863,000 863,000 597,656
5 2009 10,000,000 863,000 863,000 545,207
6 2010 10,000,000 863,000 863,000 497,361
7 2011 10,000,000 863,000 863,000 453,714
8 2012 10,000,000 863,000 863,000 413,897
9 2013 10,000,000 863,000 863,000 377,574
10 2014 10,000,000 863,000 863,000 344,439
11 2015 0 10,000,000 10,000,000 3,640,929
Total 8,630,000 18,630,000 9,031,372
PREFERRED STOCK
Number of Warrants per Preferred Stock 13
Face Value of the Preferred Stock $100
Stock Price of each Warrant $77
Conversion Premium ($ 77 – $ 64) 13
Amount of Preferred Stock (without Poly Pipe) $ 8,000,000
Face Value $100
No of Bonds 80000
Conversion Premium $ 1,040,000
Repayment at $ 105 per stock $ 8,400,000
Amount of Preferred Stock (without Poly Pipe) $ 13,000,000
Face Value $100
No of Bonds 130000
Conversion Premium $ 1,690,000
Repayment at $ 105 per stock $ 13,650,000
Without Poly Pipe Purchase
Amount of 9.38% 9.62%
Preferred Principal Dividend Cash PV
Year Stock Payment Payment Outlay of cash outlay
1 8,000,000 750,400 750,400 684,547
2 8,000,000 750,400 750,400 624,472
3 8,000,000 750,400 750,400 569,670
4 8,000,000 750,400 750,400 519,677
5 8,000,000 750,400 750,400 474,071
6 8,000,000 750,400 750,400 432,468
7 8,000,000 750,400 750,400 394,516
8 8,000,000 750,400 750,400 359,894
9 8,000,000 750,400 750,400 328,310
10 8,000,000 750,400 750,400 299,499
11 8,000,000 750,400 750,400 273,215
12 8,000,000 750,400 750,400 249,239
13 8,000,000 750,400 750,400 227,366
14
15 8,400,000 8,400,000 2,118,031
Total 9,755,200 18,155,200 7,554,975
With Poly Pipe Purchase
Amount of 9.38% 9.62%
Preferred Principal Dividend Cash PV
Year Stock Payment Payment Outlay of cash outlay
1 13,000,000 1,219,400 1,219,400 1,112,388
2 13,000,000 1,219,400 1,219,400 1,014,768
3 13,000,000 1,219,400 1,219,400 925,714
4 13,000,000 1,219,400 1,219,400 844,475
5 13,000,000 1,219,400 1,219,400 770,366
6 13,000,000 1,219,400 1,219,400 702,761
7 13,000,000 1,219,400 1,219,400 641,088
8 13,000,000 1,219,400 1,219,400 584,828
9 13,000,000 1,219,400 1,219,400 533,504
10 13,000,000 1,219,400 1,219,400 486,685
11 13,000,000 1,219,400 1,219,400 443,975
12 13,000,000 1,219,400 1,219,400 405,013
13 13,000,000 1,219,400 1,219,400 369,470
14 0
15 13,650,000 13,650,000 3,441,800
Total 14,632,800 29,502,200 12,276,835
BANK LOAN
11.50% 9.62%
Balance of Principal Interest Cash PV
Year Debt Payment Payment Outlay of cash outlay
1 2005 10,000,000 1,150,000 1,150,000 1049079
2 2006 10,000,000 2,000,000 1,150,000 3,150,000 2621386
3 2007 8,000,000 2,000,000 920,000 2,920,000 2216733
4 2008 6,000,000 2,000,000 690,000 2,690,000 1862915
5 2009 4,000,000 2,000,000 460,000 2,460,000 1554126
6 2010 2,000,000 2,000,000 230,000 2,230,000 1285186
Total 10,000,000 4,600,000 14,600,000 10,589,425
Stated value/stated amount of interest is 11.50%
researched value of similar debt is 9.62% (WACC)
Repayment of principal In 5 Years at $ 2,000,000 per year
WACC CALCULATION
WACC
amount pre-tax after tax weight amount
Bank Loan 7,500,000.00 6.00% 3.60% 17.26% 0.62%
retained earnings are $21mm Mortgage Bond 5,000,000.00 7.50% 4.50% 11.50% 0.52%
Common Stock 9,587,500.00 11.90% 11.90% 22.06% 2.63%
Retained Earnings 21,372,500.00 11.90% 11.90% 49.18% 5.85%
43,460,000.00
9.62%
MWACC
amount pre-tax after tax weight amount
Bank Loan 5,450,000.00 6.25% 3.75% 8.55% 0.32%
Rondo doesn’t have Swiss loan Mortgage Bond 5,492,832.40 6.32% 3.79% 8.62% 0.33%
rondo doesn’t have bond Common Stock 29,330,000.00 11.90% 11.90% 46.02% 5.48%
Retained Earnings 23,467,100.00 11.90% 11.90% 36.82% 4.38%
63,739,932.40
10.50%
Notes:
Bank loan is PV of the final 2006 and 2007 amount. Amount from relates to current PV discount rate
mortgage bond is add of PV of 2007-end of bond. Amount is discount rate from prior week
Common stock — $29.33 per share calculated. 1mm shares outstanding (previous week)
Retained Earnings from 2006 from week 2
CAPM is same for each. Calculated from previous week.

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