Question
Do you think your friend should buy bonds in this company? (Practice) You have been approached by an investor friend for some advice. He is
Do you think your friend should buy bonds in this company? (Practice)
You have been approached by an investor friend for some advice. He is considering purchasing bonds in a new company that has recently started up and is producing a commodity. The company is a ring-fenced entity, which means the banking consortium which provided the debt only has a call on the plant assets, not the balance sheet of the parent companies involved. 60% of the capital cost of the plant was debt financed with 40% of the capital coming from owners' equity.
With this project financed arrangement, the bank consortium had significant warranties provided by the company and their contractors to warrant successful initial operation of the plant. The plant is now running successfully and passed its performance warranty test run 6 months ago. The debt arrangements between the banks and the company are somewhat restrictive from the company's perspective and require that the company maintains a strict interest cover ratio. In essence this means the company must have enough cash to pay 2 times the monthly interest at any time. This limits the company's ability to pay dividends and may restrict future investments in other
plants. The company would prefer more financial flexibility and intends to raise bonds to pay off the bank debt. The current bank interest rate is 6% and it is expected the bond rate will be 8.5%.
Note: bond holders earn a higher interest rate but have less favorable covenants, banks have a lower interest rate but impose more restrictive covenants against the company.
The following represent the main accounting parameters of the company in USD as of the start of production (6 months ago).
1.Long term Liabilities: $1.2 billion
2.Long term Assets: $2 billion
3.Equity: $0.8 billion
4.Accounts payable = Accounts receivable
5.Retained earnings/cash reserves = $100 million
6.Projected revenue: $800 million/yr (at current commodity price)
7.Feedstock costs: $250 million/yr
8.Expenses: $150 million/yr
9.Bank interest rate: 6% (no capital needs to be repaid)
10.Bond interest rate 8.5% (capital repaid in 30 years)
11.Depreciation: $133.3 million per year (fixed for 15 years)
12.Tax rate: 30%
Historical trends indicate the commodity involved varies in price from the current price by up to +/- 30%, but has a normal fluctuation range of +/- 10%.
Assume the bonds will be issues at the end of year 1. You might want to construct a simplified P&L and Balance Sheet and look at the Company's economic performance assuming a plant life of 30 years. Do you think your friend should buy bonds in this company? Provide a recommendation with
justification to support your recommendation. If you believe you have been given insufficient information you should estimate other information and state this information as an assumption and think whether of the impact if your assumptions are incorrect. You should be able to provide an answer to your friend without needing a detailed economic analysis and associated WACC, or investors target return on equity.
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