HIGH ROCK INDUSTRIES CASEAwa Traore, Bony Faliandri Hudi, Citra Rinanti TP. & Irwan Arfandi B.

Master of Management – Gadjah Mada University

Brief Summary• High Rock Industries (HRI) was engaged in purchase of

underdeveloped acreage which was then developed for industrial use.

• Crawford’s attention has been drawn to an area of land which is located on the west of Washington D.C. along the border shared by Maryland and Virginia.

• HRI considered the asking price of $6 million to be most reasonable

• Crawford’s financial staff assured her of an increase in HRI’s earnings before interest and taxes (EBIT) of 20 percent

How to get 6 million?• Debt: $6 millions of straight debentures, with a 7% coupon and a

15 year maturity. Flotation cost of $200.000. There was also the possibility of a sinking fund of $400.000 per year, although all parties thought this unlikely with regards to the existing level of interest rates and the company’s reputation.

• Equity: An equity issue could be sold to the public.

• Preferred stock: One-hundred-dollars per share preferred stock could be sold to net the company $93.50 per share after brokerage fees. The yield on preferred stock of equivalent quality is 8 percent.

THEORETICAL BACKGROUND

Equity Financing“ Equity financing is when you (the business owner) sell an ownership interest in your business in exchange for money. The business owner and the investor(s) shares the business and the risks that come with it”

• Advantages of Equity FinancingCash flow that would have been used to repay the loan, can be used to grow the business.

• Dis-Advantages of Equity Financing

Loss of interest of ownership of your business and also the possible loss of complete control that can accompany a sharing of business ownership with investors.

Debt financing“Debt financing means taking out a loan (money that is to be paid back over a certain period of time, usually with interest)”

Advantages of Debt Financing• Lending party does not gain any part of ownership of your business

and your only obligation to lending party is to repay the debt

• Dis-Advantages of Debt FinancingThe biggest dis-advantage is that the business will not have all of its cash flow available to do business. Also, the interest that is owed can be high

Investment Banker An individual or institution which acts as an underwriter or agent for corporations and municipalities issuing securities

• Most also maintain broker/dealer operations, maintain markets for previously issued securities, and offer advisory services to investors

• Unlike traditional banks, investment banks do not accept deposits from and provide loans to individuals

Debenture• Long-term debt instrument used by governments and large companies

to obtain funds

• It is defined as "a debt secured only by the debtor’s earning power, not by a lien on any specific asset

• It is similar to a bond except the securitization conditions are different

Sinking Fund and Flotation Cost

• What Does Sinking Fund Mean?A means of repaying funds that were borrowed through a bond issue. The issuer makes periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market

• What Does Flotation Cost Mean?The costs associated with the issuance of new securities. Flotation costs include both the underwriting spread and the costs incurred by the issuing company from the offering

ANSWERING THE QUESTION

1. Does the proposed acquisition seem to fit HRI’s business pattern? Why or why not?

• Pattern is not a standard• Give higher EBIT

FIT

2. Should the proposed acquisition be financed with debt, preferred stock, or common equity? And what are the relevant decision criteria?

HIGH ROCK INDUSTRIES OLD DEBT EQUITY PREFF STOCK

Revenue 10.000.000 10.600.000 10.882.140 11.272.140

Cost of sales 5.589.300 5.589.300 5.589.300 5.589.300

Flotation cost 200.000 - -

Sinking cost 400.000 - -

Brokerage fees - - 390.000

EBIT 4.410.700 5.292.840 5.292.840 5.292.840

Interest 2.375.000 2.795.000 2.375.000 2.375.000

Taxable income 2.035.700 2.497.840 2.917.840 2.917.840

Taxes (30%) 610.710 749.352 875.352 875.352

Profit after tax 1.424.990 1.748.488 2.042.488 2.042.488

2. Should the proposed acquisition be financed with debt, preferred stock, or common equity? And what are the relevant decision criteria?

HIGH ROCK INDUSTRIES BALANCE SHEET: EQUITY Current asset 7.500.000 Net Fixed Asset 52.000.000 Total asset 59.500.000

Current Liabilties 500.000 Long term debt 25.000.000 Common stock 26.000.000 Retained Earnings 8.000.000 Total liabilities and equity 59.500.000

HIGH ROCK INDUSTRIES BALANCE SHEET: PREF STOCKCurrent asset 7.110.000 Net Fixed Asset 52.000.000 Total asset 59.110.000

Current Liabilties 500.000 Long term debt 25.000.000 Common stock ($20) 20.000.000 Preffered Stock ($93.5) 5.610.000 Retained Earnings 8.000.000 Total liabilities and equity

59.110.000

HIGH ROCK INDUSTRIES BALANCE SHEET DEBT Current asset

7.500.000 Net Fixed Asset

52.000.000 Total asset

59.500.000

Current Liabilties 500.000

Long term debt 31.000.000

Common stock ($20 par) 20.000.000

Retained Earnings 8.000.000

Total liabilities and equity 59.500.000

2. Should the proposed acquisition be financed with debt, preferred stock, or common equity? And what are the relevant decision criteria?

DEBT EQUITY PS

CURRENT RATIO 15,0000 15,0000 14,2200

TOTAL ASSET TURNOVER 0,1782 0,1829 0,1907

DEBT RATIO 0,5294 0,4286 0,4314

ROA 0,0294 0,0343 0,0346

ROE 0,0874 0,0786 0,1021

TIE 1,8937 2,2286 2,2286

DEBT TO EQUITY RATIO 1,1250 0,7500 0,7476

So, go for the preffered stock!

2. Decision Criteria

F = FlexibilityR = RiskI = IncomeC = ControlT = TimingO = Other

Some common "other" considerations are:Asset structureFloatation costsSpeedManagement attitudesExposureMarket valuation

3. What information and data are most useful in answering question 2

Net income, Profitability ratio like ROA and ROE, and debt management ratio like TIE and Debt ratio.

4. Calculate HRI’s debt to total asset ratio and the times interest earned ratio before and after new capital is acquired. Assume a 20 % increase in

current liabilities and a 20 % increase in current assets

Debt/Total Asset TIE

OLD 0,4758 1,8571

DEBT 0,5180 1,8937

EQUITY 0,4197 2,2286

PREF STOCK 0,4229 2,2286

5. Effect of sinking fund requirement in the calculation of financing possibilities

Because of the cash drain caused by sinking‑fund requirements, the financial manager might be concerned with the uncommitted earnings per share related to each financing plan

6. Additional information that could be useful in the analysis of HRI:

Back to FRICTO

SpeedManagement attitudes

Control

7. The meaning and usefulness of the probability estimate of the level of EBIT after the purchase

Probability estimate of the level of EBIT will be used to forecast the income, and used to compare the benefit vs the cost of alternatives

8. Information that should have been provided by the investment bankers

•Ranking of other firms bonds in the same industry for comparison

•Market condition

8. Information that should have been provided by the investment bankers

•Ranking of other firms bonds in the same industry for comparison

•Market condition

9. Keep a debt to asset ratio in the area of 48-55%, and issue new debt of $6 mill. How will this affect the flexibility of HRI?

• New debt to asset: 31/59.5 = 52 %, which is lower than 55

• Give them flexibility again

10. If flexibility, risk and income are the major factors in the financing selection, how should these be defined and measured

• Flexibility, refers to the future financing options for management (Debt to Asset ratio)

• As capital is raised, the choice among alternatives for raising capital in the future may be narrowed

10. If flexibility, risk and income are the major factors in the financing selection, how should these be defined and measured

• Risk and income are so interrelated they cannot be discussed separately

• Higher risk demand higher return

Debt Ratio = Total Liabilities Total Assets

Times Interest = EBIT Earned (XIE) Interest ExpenseFixed Charge = EBIT + TDFC Coverage Interest + TDFCDebt Service = EBIT + DEP + TDFC + NTDFC Coverage Interest + TDFC + NTDFC/(1 tx) ‑where:TDFC = Tax deductible fixed charges other than interest (lease payments, etc.) NTDFC = Non tax deductible fixed charges (principal repayment, etc.)‑

To calculate the risk

TIME TO DISCUSS