Question

You have been approached by an investor friend for some advice. She 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 to have 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 favourable 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).

Long term Liabilities: $1.2 billion

Long term Assets: $2 billion

Equity: $0.8 billion

Accounts payable = Accounts receivable

Retained earnings/cash reserves = $100 million

Projected revenue: $800 million/yr (at current commodity price) Feedstock costs: $250 million/yr

Expenses: $150 million/yr

Bank interest rate: 6% (no capital needs to be repaid)

Bond interest rate 8.5% (capital repaid in 30 years)

Depreciation: $133.3 million per year (fixed for 15 years)

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.

Answer 1

Long term Liabilities: $1.2 billion

Long term Assets: $2 billion

Equity: $0.8 billion

Accounts payable = Accounts receivable

Retained earnings/cash reserves = $100 million

Projected revenue: $800 million/yr (at current commodity price) Feedstock costs: $250 million/yr

Expenses: $150 million/yr

Bank interest rate: 6% (no capital needs to be repaid)

Bond interest rate 8.5% (capital repaid in 30 years)

Depreciation: $133.3 million per year (fixed for 15 years)

Tax rate: 30%

Interest Charged: 120*8.5 =$102 Profit and Loss A/c Particular Amount 1.Revenue 800 Expenses 150 Depreciation 133.3 Interest 102 2.Total expenses 385.3 Profit (1-2) 414.7 less: Tax @30% 124.41 3.Profit after tax 290.29 case 1 Revenue +10% 880 Total expenses 385.3 Profit 494.7 less: Tax @30% 148.41 3.Profit after tax 346.29 case 2 Revenue -10% 720 Total expenses 385.3 Profit 334.7 less: Tax @30% 100.41 3.Profit after tax 234.29 Particular Amount (mill $) Long Term Liabilities 1,200 Equity (Capital): incd 100 mill Retained earnings 800 Total 2,000 Assets 2,000 Total 2,000