Financial Decision Making at EduSoft Inc.: Evaluating Funding Alternatives

by | Jul 17, 2024 | finance

Mini Case
Paul Duncan, financial manager of EduSoft Inc., is facing a dilemma. The firm was founded 5 years ago to provide educational software for the rapidly expanding primary and secondary school markets. Although EduSoft has done well, the firms founder believes an industry shakeout is imminent. To survive, EduSoft must grab market share now, and this will require a large infusion of new capital.

Because he expects earnings to continue rising sharply and looks for the stock price to follow suit, Mr. Duncan does not think it would be wise to issue new common stock at this time. On the other hand, interest rates are currently high by historical standards, and the firms B rating means that interest payments on a new debt issue would be prohibitive. Thus, he has narrowed his choice of financing alternatives to (1) preferred stock, (2) bonds with warrants, or (3) convertible bonds.

As Duncans assistant, you have been asked to help in the decision process by answering the following questions.

How does preferred stock differ from both common equity and debt? Is preferred stock more risky than common stock? What is floating rate preferred stock?
How can knowledge of call options help a financial manager to better understand warrants and convertibles?
Mr. Duncan has decided to eliminate preferred stock as one of the alternatives and focus on the others. EduSofts investment banker estimates that EduSoft could issue a bond-with-warrants package consisting of a 20-year bond and 27 warrants. Each warrant would have a strike price of $25 and 10 years until expiration. It is estimated that each warrant, when detached and traded separately, would have a value of $5. The coupon on a similar bond but without warrants would be 10%.
(1)What coupon rate should be set on the bond with warrants if the total package is to sell at par ($1,000)?
(2)When would you expect the warrants to be exercised? What is a stepped-up exercise price?
(3)Will the warrants bring in additional capital when exercised? If EduSoft issues 100,000 bond-with-warrant packages, how much cash will EduSoft receive when the warrants are exercised? How many shares of stock will be outstanding after the warrants are exercised? (EduSoft currently has 20 million shares outstanding.)
(4)Because the presence of warrants results in a lower coupon rate on the accompanying debt issue, shouldnt all debt be issued with warrants? To answer this, estimate the anticipated stock price in 10 years when the warrants are expected to be exercised, and then estimate the return to the holders of the bond-with-warrants packages. Use the corporate valuation model to estimate the expected stock price in 10 years. Assume that EduSofts current value of operations is $500 million and it is expected to grow at 8% per year.
(5)How would you expect the cost of the bond with warrants to compare with the cost of straight debt? With the cost of common stock (which is 13.4%)?
(6)If the corporate tax rate is 25%, what is the after-tax cost of the bond with warrants?

 

Sample Answer

Sample Answer

 

Essay Title: Financial Decision Making at EduSoft Inc.: Evaluating Funding Alternatives

Introduction

Paul Duncan, the financial manager of EduSoft Inc., is confronted with the challenge of securing new capital to expand the company’s market share in anticipation of an industry shakeout. This mini-case analysis delves into the considerations surrounding the choice between preferred stock, bonds with warrants, and convertible bonds as financing alternatives. By examining the characteristics of each option and addressing specific questions posed by Mr. Duncan, this essay aims to provide insights into the optimal funding strategy for EduSoft Inc.

Part 1: Understanding Financing Alternatives

Preferred Stock

Preferred stock combines features of both common equity and debt. While preferred stockholders have a claim on assets ahead of common equity holders, they do not typically have voting rights. Preferred stock carries a fixed dividend payment, similar to bond interest, but is not tax-deductible like interest on debt.

Risk Comparison

Preferred stock is generally considered less risky than common stock due to its preference in receiving dividends and assets in case of liquidation. However, it is riskier than debt as missed dividend payments can lead to default.

Floating Rate Preferred Stock

Floating rate preferred stock is a type of preferred stock where the dividend rate adjusts periodically based on market interest rates. This provides protection against interest rate fluctuations but may result in lower fixed income compared to traditional preferred stock.

Part 2: Role of Call Options in Financial Decision Making

Understanding call options can aid financial managers in comprehending warrants and convertibles. Call options grant the holder the right to buy an underlying asset at a predetermined price within a specified period. Warrants are similar to call options but are issued by the company itself. Convertibles are hybrid securities that allow conversion into a predetermined number of shares of common stock.

Part 3: Analysis of Bond-with-Warrants Package

1. Coupon Rate Calculation: To sell the bond-with-warrants package at par ($1,000), the coupon rate on the bond should be set at a level that factors in the value of the warrants.

2. Warrants Exercise: Warrants are expected to be exercised when the stock price exceeds the strike price. A stepped-up exercise price may adjust the strike price based on certain conditions.

3. Capital Inflow: The cash received when warrants are exercised contributes additional capital to EduSoft. Calculations based on the number of bond-with-warrant packages issued and outstanding shares after exercise are essential for financial planning.

4. Debt Issuance Strategy: While warrants may lower coupon rates, issuing all debt with warrants may not be advisable. Estimating stock price in 10 years and return to bond-with-warrant holders is crucial for decision-making.

5. Cost Comparison: Comparing the cost of the bond with warrants to straight debt and common stock helps evaluate the most cost-effective financing option for EduSoft.

6. After-Tax Cost: Calculating the after-tax cost of the bond with warrants involves considering the tax implications and adjusting the cost of debt accordingly.

Conclusion

In conclusion, evaluating financing alternatives requires a comprehensive understanding of preferred stock, bonds with warrants, and convertibles, as well as the role of call options in financial decision making. By analyzing the specifics of the bond-with-warrants package and assessing its impact on capital inflow, cost comparison, and after-tax considerations, financial managers like Paul Duncan can make informed decisions to support EduSoft’s growth and sustainability in a competitive market environment.

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