Daron (dec 95 adapted). Kaplan kit question number 3

(iii) If the political party A wins the election, diversify operations by buying a going
concern in the hotel industry at a cost of $9 million. The purchase would be financed
by the issue of 10% convertible debentures. Issue costs are 2% of the gross sum
raised. Daron has no previous experience of the hotel industry.
Financial projections of the hotel purchase
$ (million)
20X4 20X5 20X6 20X7 20X8
Revenue 9 10 11 12 13
Variable costs 6 6 7 7 8
Fixed costs 2 2 2 2 2
Other financial data:
Incremental working capital 1 – – 1 –
Tax allowable depreciation is negligible for the hotel purchase. The after-tax
realisable value of the hotel at the end of year 20X8 is expected to be $10 million,
including working capital. The systematic risk of operating the hotels is believed to be
similar to that of the company’s existing operations.
Details of the possible convertible debenture issue for the purchase of the hotel are
shown below:
10% $100 convertible debentures 20Y7 (i.e. 14 years from now), issued and
redeemable at par. The debentures are convertible into 60 ordinary shares at any
date between 1 January 20X9 and 31 December 20Y1. The debentures are callable
for conversion by the company subject to the company’s ordinary share price
exceeding 200 centos between 1 January 20X9 and 31 December 20Y1, and puttable
for redemption by the debenture holders if the share price falls below 100 centos
between the same dates.
Required:
Discuss the implications for Daron if the diversification is financed with convertible
debentures with these terms.

Answer –

Daron’s current gearing, measured by the book value of medium and long term loans
to the book value of equity is: 14/22 or 63.6%
No information is provided about short-term loans which would increase this gearing
figure further. A $9 million convertible debenture issue would initially increase
gearing to 23/22 = 104.5%.
Such a high level of gearing involves ‘high’ financial risk, especially for a company in a
declining industry. The coupon rate of 10%, or $918,400 interest per year would have
to be paid for five years or more. Convertible debentures normally carry lower
coupon rates than straight debt. Daron can borrow long term from its bank at
10% per year, and the 10% coupon on the convertible appears to be expensive.
However, this could be explained by the market seeking a relatively high return
because of the size of the loan.
If conversion takes place the gearing level will fall, but this is will not occur for at least
five years. At the $100 issue price the effective conversion price is $100/60 or
167 centos per share
This represents an average share price increase of 12.7% per year over five years,
which is possible if market prices in general increase, but is by no means guaranteed.
The existence of the call and put options has potentially significant implications for
Daron plc. The call option allows the company to limit the potential gains made by
debenture holders. If the share price reaches 200 centos between 1 January 20X9
and 31 December 20Y1 the company can force the debenture holders to convert,
giving maximum capital gains on conversion of 33 centos per share (relative to the
$100 issue price). This is a small gain and may not be popular with investors. If the
share price falls below 100 centos between the same dates, the debenture holders
can ask the company to redeem the debentures at par, forcing the company to find
$9 million for repayment of the debentures. If the market price of the shares has only
moved by a maximum of eight centos over five years, the company might experience
difficulty refinancing the $9 million, leading to severe problems in finding the cash for
redemption.

I do not understand how they got the figure 22 (equity) and 167 centos and 33 centos. Can you briefly explain this ?

Thank you.