Your Group has been asked to consult with HMK Enterprises on how best to raise $10 million to finance new capital expenditures. The first option being considered is to issue five-year bonds with a face value of $1,000 and a coupon rate of 6.5% (annual payments).
I. To help the company decide on how best to proceed, your Group has derived the following table that summarizes the current financial market yield to maturity for five-year (annual payments) coupon corporate bonds of various ratings:
Rating AAA AA A BBB BB
YTM 6.20% 6.30% 6.50% 6.90% 7.50%
a. if Standard & Poor’s or Moody’s puts a rating on the bonds as AA, what will the price of the HMK bonds be when issued to investors?
b. to raise the $10M needed, how much total principal amount of these bonds must HMK issue to raise the money today, if the bonds are in fact rated AA? (assume that any fraction of a bond is rounded off to the nearest whole number)
c. what must the rating of the HMK bond be for them to sell at par?
d. suppose that when the bonds are issued, the price of each bond ends up at $959.54. Is this a discount bond or a premium bond? What do you think would be the likely rating of the bonds? Is it possible that your Group could advise management that this would basically be nothing more than the issuance of junk bonds by HMK? Would this be a good or bad thing to do, in your opinion, relative to the overall cost of capital to finance this investment? Why?
e. in discussing this with Mr. Moneypockets, the CFO, will you explain that the cost of the bonds to the corporation (assuming no financing costs that might be paid to an Investment Banker) could be greater or less than the coupon rate? In this case, based on your answer to part d., which will it be? What factors, such as riskiness of cash flows from the potential investment or the current debt load of HMK, might contribute to your explanation?
II. As an alternative, your Group decides to look at equity financing, which can be either the use of retained earnings from the right-hand side of the balance sheet (with the corresponding assets being short-term investments in current assets, or very large amounts in the cash account in current assets, or the disposal of other less efficient longer-term assets), or in the current case, the issuance of new common stock to finance the investment. But, in order to “get at” the cost of this new common stock equity, you have to review a few fundamentals with Mr. Moneypockets first.
a. your Group notes that HMK has just paid an annual dividend of $1.50. Analysts are predicting the dividend to grow by $0.12 per year over the next five years. After then, HMK’s earnings are expected to grow by 6% per year, and its dividend payout rate will remain constant. If HMK’s cost of capital (which is what we are eventually seeking for the overall weighted average cost of capital) is assumed to be 8.5% by your Group, what price will you tell Mr. Moneypockets that HMK stock should be selling for today, using the dividend-discount model as your technique?
b. alternatively, your Group expects free cash flows to be generated over the next five years as follows for HMK:
Year 1 2 3 4 5
FCF ($M) 53 68 78 75 82
After then, your Group expects the free cash flows to grow at the industry average of 6% per year (same rate as the growth in dividends after the first five years, per above).
If you now switch to the discounted free cash flow model as an alternative, and use the same estimate of 8.5% as the equity cost of capital:
--what will you tell Mr. Moneypockets that his “enterprise value” will be for HMK?
--if HMK has no excess cash that can be used for this investment, but already has $300M of debt (none of which includes Option I debt financing above), and 40M shares outstanding of common stock, what will be your estimate of the stock price to Mr. Moneypockets?
c. what conclusions can your Group give Mr. Moneypockets relative to the differing stock price estimates that might result from these two approaches to stock price estimation? What could account for the differences in the two stock price approaches?
d. If the price of the stock is roughly $62 when issued (and assuming no flotation costs such as paid to an Investment Banker), how many shares of new stock will have to be issued in the primary market to major investors such as CalPERS (California Pension Fund System) and the AFL-CIO Pension Fund, in order to raise the $10M?