Question

Scenario Puma Co is a listed company based in Australia and uses the $ as its currency. The company was formed around 20 years ago and was initially involved in cybernetics, robotics and artificial intelligence within the information technology industry. At that time due to the risky ventures Puma Co under took, its cash flows and profits were very varied and unstable. Around 10 years ago, it started an information systems consultancy business and a business developing cyber security systems. Both these businesses have been successful and have been growing consistently. This in turn has resulted in a stable growth in revenues, profits and cash flows. The company continues its research and product development in artificial intelligence and robotics, but this business unit has shrunk proportionally to the other two units. Just under eight years ago, Puma Co was successfully listed on Australia ’s national stock exchange, offering 60% of its share capital to external equity holders, whilst the original founding members retained the remaining 40% of the equity capital. The company remains financed largely by equity capital and reserves, with only a small amount of debt capital. Due to this, and its steadily growing sales revenue, profits and cash flows, it has attracted a credit rating of A from the credit rating agencies. At a recent board of directors (BoD) meeting, the company’s chief financial officer (CFO) argued that it was time for Puma Co to change its capital structure by undertaking a financial reconstruction, and be financed by higher levels of debt. As part of her explanation, the CFO said that Puma Co is now better able to bear the increased risk resulting from higher levels of debt finance; would be better protected from predatory acquisition bids if it was financed by higher levels of debt; and could take advantage of the tax benefits offered by increased debt finance. She also suggested that the expected credit migration from a credit rating of A to a credit rating of BBB, if the financial reconstruction detailed below took place, would not weaken Puma Co financially Financial reconstruction strategy for the company The BoD decided to consider the financial reconstruction plan further before making a final decision. The financial reconstruction plan would involve raising $1,320 million ($1·32 billion) new debt finance consisting of bonds issued at their face value of $100. The bonds would be redeemed in five years’ time at their face value of $100 each. The funds raised from the issue of the new bonds would be used to implement one of the following two proposals:

Proposal-1 Either buy back equity shares at their current share price, which would be cancelled after they have been repurchased; or Proposal 2: Invest in additional assets in new business ventures Puma Co, Financial information Extract from the forecast financial position for next year Other financial information

Current government bond yield curve

Year 1 2 3 4 5 Yield % 1·5% 1·7% 1·9% 2·2% 2·5%

Yield spreads(in basis points)

Year 1 2 3 4 5 A 40 49 59 68 75 BBB 70 81 94 105 112 BB 148 167 185 202 218

The finance director wants to determine the percentage change in the value of Puma Co’s current bonds, if the credit rating changes from A to BBB. Furthermore, she wants to determine the coupon rate at which the new bonds would need to be issued, based on the current yield curve and appropriate yield spreads given above.

Puma Co’s chief executive officer (CEO) suggested that if Puma Co paid back the capital and interest of the new bond in fixed annual repayments of capital and interest through the five-year life of the bond, then the risk associated with the extra debt finance would be largely mitigated. In this case, it was possible that credit migration, by credit rating companies, from A rating to BBB rating may not happen. He suggested that comparing the duration of the new bond based on the interest payable annually and the face value in five years’ time with the duration of the new bond where the borrowing is paid in fixed annual repayments of interest and capital could be used to demonstrate this risk mitigation

Required:

1. Read the case and discuss the possible reasons for the finance director’s suggestions that Puma Co could benefit from higher levels of debt with respect to risk, from protection against acquisition bids, and from tax benefits.

If you are not familiar with any technical term, don’t be afraid. Conduct a research. You are expected to write answer based on the conception of risk and capital structure. A general view is required rather than detail analysis.

2. How you will assess risk attitude of an organisation? Describe few parameters of risk.

3. How PUMA can optimise their risk management strategy.

4.Explain briefly what is the purpose of maintaining and establishing inventories of assets and liabilities by capturing up-to-date accounting records? And how this is maintained?

Answer 1

4) Purpose of maintaining inventories of assets & liabilities:

     The following can be the purposes of maintaining assets & liabilities:

• This can be for managing the risks that can arise as a result of mismatch between assets & liabilities.
• The process involves maximizing the assets to meet complex liabilities that can increase the profitability.
• The traditional approach focuses on interest rate & liquidity risk because they are the most prominent risks affecting the balance sheet of the organization.
• In other words, the maintenance of inventories of assets & liabilities is the management of spread between interest rate sensitive assets & interest rate sensitive liabilities.

The following are the actions to be performed:

     First step is projecting the future funding needs by tracking the maturity & cash flow mismatches gap risk exposure. In this situation, the risk depends not only on maturity of asset liabilities but also on the maturity of each intermediate cash flow including pre payment of loans or unforeseen credit of usage lines.

3) Risk management optimization strategy:

This involves three steps that are to followed by PUMA:

• The company can try to be away from using the past operating budgets & models. The company can consider the future risk landscape future risk by developing tomorrow’s risk management strategies.
• Prioritize tasks that are critical & also require abundant time of the manager this is necessary to ensure that subordinates balance their tasks accordingly on the basis of priority & demands.
• Recognize the tasks that internal operations pose gate to strategic risks. This is necessary to outsource certain operations to specialized professional people.

2) How can a risk attitude are assessed:

The risk attitude can be measured by risk attitude scale which distinguishes between two psychological variables namely risk perception & attitude towards perceived risk that have been confounded in previous risk attitude indices. Next is the scale that examines risk taking & its determinants in several areas. The tests of the scale & the model that underlies it confirms that risk taking is content specific as well as gender differences in risk taking are as much function of differences in risk perception than differences in attitude towards perceived risks.

1. The reasons for finance director’s suggestions to go for high levels of debt:

• The company can retain control: when a company agrees for debt financing from a lending institution the lender cat interfere in the management of the company. It is the owner who makes all the decisions. The relationship with the lender ends once the loan is repaid fully.
• Tax advantage: the amount paid as interest on debt is tax deductible which ultimately reduces the company’s net obligation.
• Easy planning: the company can make plans easily on their finance & budget decisions. This is because he principle & interest to be paid is well known by the company in advance.