The Star Bay Company - Analysis of Decisions Taken by Thomas McGill - Case Study Example

The Star Bay Company Case Year wise Analysis of Decisions Taken by Thomas McGill Star Bay Company (SBC) was established in 1983 and Thomas McGill’s major decision were taken from 1990 onwards. This is because the company needed major external funding as the sales of the company had gone down in the last three years by about 5% each year from 1986 to 1989, even though earnings had been constant. Three reasons were largely accounted for this downtrend. One, since the company was into a research and development phase, the costs thus incurred were high; two, the research and development programs recommended for the development of certain new plant facilities for new product manufacture; and three, the current revenues could not offset the start-up costs of these new facilities. Another reason for massive external funding was the stock price in 1990 and the earnings per share thereof, which stood at $10 and %1 respectively, while for the other firms price earnings ratio stood at 18 and was showing better growth and earnings per share. 1990 McGill being the executive Vice President Finance had the onus of taking sensitive financial decisions under these circumstances, even though SBC had a relatively lower debt ratio against the overall industry ratio. But the total increase in net assets was forecast to be around 30% to raise it to $104 million from$80 million. Since retained earnings were expected to raise $4 million of these funds during this year, $20 million more had to be raised. McGill’s recommendation to take a combined action on the alternative suggested in the board meeting was appropriate as it divided $20 million raise between two options of selling 50% through common stock and obtaining 50% through long term bonds. That separated the $20 million expectation between $10 million each. McGill’s decision came after the management presented the board with three options, which were issuance of a commercial paper at 4.25% interest rate, long-term non-convertible bonds at 5%, sell common stock at per share value of $9. McGill’s has taken these decisions in the right earnest and spirit and has been justified to do so. Debt and equity are the two major ways of seeking external funding. When a company opts for the former, it enters a debt funding option by issuing debentures which it later has to pay back as till then the company is in debt to those who hold its bonds (BusinessFiance.com). McGill opted for the latter where he raised 50% of the desired $20 million by selling stock. It cannot be said that what McGill did was wrong as both sources of raising external finance have their respective pros and cons. Though arguably equity funding is generally considered to be more advantageous than debt funding as it is committed to a business and investors are attracted to a business only if the business is doing well, the businesses do away with the liability of servicing a debt loan, investors have as much interest in the business as do owners as the stakes are embedded, and both sides expect the business to deliver a value (BusinessLink.gov.uk). 1992 SBC did not need any external funding at this stage for running its internal operations and 1990 onwards till this year it was doing fairly well – its share price increased to $4 from $1, and the stock price went up to an astonishing $88 from $10 in 1990. The growth was impeccable and SNC started being talked about in the investment circles. The only downside of the scenario was that no new products were being introduced into the market as envisioned through its research and development initiatives and competitor companies were taking a pie from its profit margins on account of this; even as the growth was expected by the management to stabilize at 5% per year, thus keeping up with the GDP growth of the nation. But company saw further growth in the offing if it acquired another company meant to provide it high quality motor housing. This is when a company making motor housing units, Motor Housing Products (MHP), made an offer to sell itself; however on a condition that SBC either pays in cash or of $25 million or sells its stock amounting to the same figure. The cash component put McGill in a piquant situation as cash reserves of SBC were dismally low at $6000 and the stock it would have been unwilling to shelve out. The decision, again, was vested in McGill. The decision for McGill was not an easy one as on one hand SBC needed an uninterrupted supply of high quality motor housing and on the other both conditions by MHP, which was a longtime supply partner of the company, were difficult to meet. McGill’s decision to go in for cash purchase and backed by the board of directors eventually meant that SBC had to borrow again to pay the $25 million to MHP as the company didn’t have surplus cash to do the same. Left with two options of either equity or long term borrowing, McGill preferred to go for the latter from an insurance company. The tenure was 15 years at a yearly rate of 5% interest on the amount borrowed. McGill, probably under pressure to steer further growth, picked up an option that it had actually tried to avoid in 1990. That he did not find it advisable to avail a short term from one of company’s service banks at a much lower interest rate per annum indicates that the decision was not well thought about. McGill should have realized that the decision on how a business is funded has a tremendous impact on how the business progresses (Jefferson, 2001). Even though both long term borrowing and equity are supposed to offer both advantages and disadvantages, it is upon business heads to assess both existing capital and situation of the company to take the right decision. The only advantage long term borrowing offer are tax benefits and interest payable is tax deductible, but when companies have limited cash flow and other concurrent liabilities to meet the irregularity in repayments is always a matter of concern. SBC, given its growth in share/ stock price, was doing exceptionally well but apparently that led McGill to a feel-good factor leading him to decide in favor of a long term loan. He attempted to carry debt for 15 years and carrying so much of debt for too long makes a company vulnerable to investor indifference in future. The risks are perceivable and outweigh benefits. Thus, issuing equity would have been a right thing to do in this case as one of the foremost advantages of equity is that the business being financed is not obliged to repay the money borrowed. Further if investors are high profile the business gets further strengthened by their credibility (Debt vs. Equity Financing, Online). 1995 Following the MHP takeover, it seems the business was constantly evolving in McGill mind; one reason that explains initiation of his plan towards company’s debt ratio reduction by retiring the long term debt. However, had not Wall Street experts prevailed over him this would have been another decision that could have boomeranged on the company in future. His decision to defer retiring of debt was a correct one as the markets were expected to be volatile in future and interest rates on the higher side. If McGill hadn’t deferred retiring the debt, things could have gone way beyond a limit where the company would have been able to mend them. However, he could have retired long term debt for a short term one since a business is left with a number of doors open when it goes in for a short term debt. Short term debts are supposed to leave a business with ample ready cash in order to enable it to fund its further expansion and programs. Short term debts make sure that the company meets its operational costs by ensuring sufficient cash inflow (Broemmel, nd). 1999 By now the company had seen a steady growth, but not so overwhelming; a factor seen by the company a warranting more funds through financing options. While in terms of share prices and earnings the average industry price-earnings ratio was sixteen, SBC’s stood at $2.20 each share. Since the company had earnings as part of its policy, it had been able to reduce its debt ratio to 35% this year from 44% in 1994; industry average at this point was 37%. $148 was the total SBC assets. In order to keep the growth steady, it needed an additional $15 million through funding. McGill chose convertibles to raise this money. This was a correct decision as convertible debt offers a unique feature of being converted into stock at any point in future under specific terms and conditions. Convertibles offer investors a twofold security – income along with safety that bonds offer, and two, be participants just in case there is an upside and the bonds gets converted into stock. McGill had probably realized that convertibles look more attractive to investors due to their eagerness on the bonds to rise in value as the company grows (Fedorov, nd). 2002 Refunding short term debt with long-term debt would not necessarily have strengthened company’s position as expected by McGill. Established businesses rely more on short term long, while as startups or businesses without a strong patronage and clientele prefer long term loans. It could be said that since McGill thought about this plan, internally he had started getting an uneasy feeling about the decisions he had taken previously and would likely take in future. Even though it would have mitigated the risks from the short term debt exposure, it would have added to a collective long term ones. McGill thought issuing a nonconvertible bond was a good idea, and from a company’s perspective was as companies know many investors have lucre on mind and eagerly look forward to some thing as offering an interest rate of 7.25%. On McGill’s part it was not a bad idea to use nonconvertible bonds to refund short term loans amounting to $25 million, borrowed at a much lower interest rate of 6% (Pandey & Joshi, 2011). 2004 At this point of time when SBC was in real need to expand, McGill had to first give the expansion plans a thought and later shelve the same, not because expansion did not look attractive but because to be able to avoid further debt exposure. This was a case of a flourishing company wanting to progress further but did not have ample resources to do that as the debt had accumulated drastically over the years. This could also be taken as repercussions of some decisions that McGill took previously. Although, when McGill shelved the expansion plans, the act had its natural consequence i.e., it directed McGill’s attention to what had previously not been taken so seriously – develop strategies to rationalize capital, cut costs, and restructure business. Using the net present value (NPV) to check the viability of the project and assess its profitability, figures have to be analysed based on the incoming and outgoing cash flows with respect to time series. In order for NPV to become present value (PV) of the company, outflow of the cash must only be that of purchase value and inflow must be incessant flow of cash through instruments like bonds and coupons. The situation with SBC was different. In order to raise further funds for the expansion plans, it had to $12.5 million which had to be paid immediately. A year down the line according to NPV analysis, 65% of this amount was recoverable, which puts the figure at $8.0 million. That was good news for the company and if this analysis was considered, the trend could have been termed as positive and expansion plans profitable for the company. But, as per McGill’s assessment, the company would have needed an additional $12.5 million if other operational costs of the company had to be met. If the plan were to take off, this additional burden could not have been avoided. This, in turn, would have dwindled the company’s NPV, even though 65% of the cost was recoverable in the first. Under such circumstances as according to NPV analysis, the plan would not have added much value to SBC and profitability could not have been predicted positively. McGill’s plans were good, but cash inflows were the only concern. Initial capital outlay of $12.5 million and then additional amount to the same tune was not putting SBC’s NPV at more than ‘0’; essential for any project to be accepted. Since Rt,, which is the net cash flow at time t, does not stand at a positive value; it means the investment that the company plans to make would subtract, instead of add, value to the company. However, should the cash flows in subsequent years (years 2-9) been as promising as that of year 1, the NPV might have signaled a positive value for the company. McGill had further foreseen a recessive market ahead, and one of the important actions in a recessive market is to downgrade debt. Based on the NPV analysis, where cost-benefit subtraction does not give a net benefit, it would not have been wise on part of the company to make further investments and create more debt that it would have required to downgrade a year later. 2007 More than two years into working and restructuring the business as it stood in 2004, and bringing about seemingly positive changes in the same; McGill thought the time was opportune for taking up the plan again that had been abandoned in 2004. This was a proper decision since the business was appearing to take an upturn. At this stage rejecting the long term debt option was reasonable because the circumstances had begun to change. References BusinessFinance.com. (nd). Available http://www.businessfinance.com/external-financing.htm. Accessed February 02, 2012 BusinessLink.gov.uk. (nd). Equity finance: Advantages and disadvantages of equity finance Available http://www.businesslink.gov.uk/bdotg/action/detail?itemId=1073789573&type=Resources. Accessed February 02, 2012 Broemmel, M. Demand Media. The Advantages of Short-Term Debt. Available http://smallbusiness.chron.com/advantages-short-term-debt-2038.html. Accessed February 02, 2012 Debt vs. Equity Financing. Available http://www.enotes.com/debt-vs-equity-financing-reference/debt-vs-equity-financing. Accessed January 02, 2012 Fedorov, S. (nd). Why Do Companies Choose Convertible Debt? Available http://www.ehow.com/info_7746689_do-companies-choose-convertible-debt.html. Accessed February 02, 2012 Jefferson, Steve. "When Raising Funds, Start-Ups Face the Debt vs. Equity Question." Pacific Business News, 3 August 2001. Pandey, N. & Joshi, D. (2011). Return and risk in non-convertible debentures. Business Standard. February 2012. Available at http://www.business-standard.com/india/news/returnrisk-in-non-convertible-debentures/445605/. Accessed February 02, 2012 Read More