Question

John Lee, the CFO of Mpota Limited has just completed a training program on capital structure theories. John Lee is excited about M&M propositions and has decided to issue shares and use the proceeds to buy back bonds.

(i) Based on your understanding of M&M propositions, why do you think Mr Lee has decided to issue shares and use the proceeds to buy back bonds?

(ii) Briefly describe 5 issues Mr Lee should consider before he issues shares and use the proceeds to buy back bonds.

Answer 1

The rationale behind the decision of issuing shares and using the proceeds to buy back bonds of John Lee, CFO of Mpota Ltd.:

1. Assumptions implicit to his decision:

A. Perfect Capital Market:

a) Investors are going to behave rationally.

b) There are no transaction costs.

c) Securities are infinitely divisible.

d) No investor is large enough to influence the market price of securities.

e) No floatation costs.

B. A firm has a fixed investment policy that will not change over a period of time. The financing of new investments will not change in the required rate of return.

C. No Taxes

Note: The assumption of ‘no taxes’ validates the similarity with the Net Operating Income approach (NOI) of capital structure irrelevance which states that the value of the firm remains independent from all possible combinations of debt and equity.

Considering the existence of a tax structure rather is a more practical approach while ascertaining the value of a firm which shows the result that is quite similar to the Net Income approach (NI) stating that leverage certainly affects the value of a firm.

The NI approach assumes that the cost of debt is lesser than that of the cost of equity and the risk perception of the equity shareholders remains unchanged with the increase in debt capital in the capital structure of a firm. The first assumption induces the management to raise more debt capital (or the cheaper source compared to equity, as the only two extreme fundings can be used) in the capital structure to increase the value of the firm (holding the assumption valid for the unchanged perception of risk from the equity shareholders point of view). However, in Modigliani & Miller’s approach there has been a threshold above which the rise in debt capital will increase the perception to the risk of equity shareholders thereby an additional premium would be charged from equity shareholders' point of view as compensation to the enhanced risk. If the debt capital been introduced even more in the structure the cost savings from debt is nullified against the enhanced compensation from equity shareholders part and if it still increases then the risk of payouts from debt holders part raises the cost of debt and in the ultimate total cost of raising funds (both the costs of equity and debt rises) which reduces the value of the firm.   

Therefore, as a recommendation to John Lee, CFO of Mpota Ltd., I would suggest raising debt capital to reduce the share of equity instead of doing the opposite to enhance the value of the firm subject to a certain limit. He might be tempted to issue share and buy back the bonds with their proceeds in order to reduce the debt-equity ratio affecting solvency and ultimately reducing the chance of running cash-short while pay-outs. His intention might be to reduce the financial risks which the business is exposed to. Therefore a complete nullification of his intention is subject to more information on the issue.

However, 5 issues prior to issuing shares and buy back bonds with its proceeds need consideration:

a. The prevailing cost of debt should be contrasted with the cost of equity.

b. Stable risk perception among the investors regarding pay-outs should prevail.

c. Market sensitivity should be checked before moving on the approach.

d. The value of the firm should be compared considering the existing situation and the upcoming situation.

e. Certain macro-economic indicators that might affect the decision (both in short and in the long-run) (for saying Interest rates, Inflation in the economy, Exchange rate stability as well as its fluctuations) should be looked at.