Question

QUESTION ONE

Carson Company is a large manufacturing firm in Accra that was created 20 years ago by the Carson family. It was initially financed with an equity investment by the Carson family and 10 other individuals. Over time, Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to the market interest rate and is adjusted every six months. Thus, Carson’s cost of obtaining funds is sensitive to interest rate movements. It has a credit line with a bank in case it suddenly needs additional funds for a temporary period. It has purchased Treasury securities that it could sell if it experiences any liquidity problems.

Carson Company has assets valued at about 50 million cedis and generates sales of about 100 million cedis per year. Some of its growth is attributed to its acquisitions of other firms. Because of its expectations of a strong Ghanaian economy, Carson Company plans to grow in the future by expanding its business by making more acquisitions. It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans or by issuing bonds. It is also considering issuing stocks to raise funds in the next year. Carson closely monitors conditions in financial markets that could affect its cash inflows and cash outflows and thereby affect its value.

i. In what way(s) is Carson a surplus unit? (2marks) ii. In what way(s) is Carson a deficit unit? (2marks) iii. How might finance companies facilitate Carson’s expansion? (4marks) iv. How might commercial banks facilitate Carson’s expansion? (4marks) v. Why might Carson have limited access to additional debt financing during its growth phase? vi. How might Carson use the primary market to facilitate its expansion? (2marks) vii. How can Carson use the secondary market? viii. Explain why Carson would be interested in future interest rate movements? (2marks)

NB: Each explanation should not exceed 200 words

Answer 1

Ans i.

Carson is a surplus unit. Surplus unit is a unit that provides funds to the financial markets. In this case, Carson has bought Treasure securities from the financial markets. Since it has provided its excess funds to the market by buying securities, it is a surplus unit.

Ans ii.

Carson is a deficit unit. A deficit unit is a unit that obtains funds form the financial markets. In this case, Carson has obtained loans from finance companies and commercial banks. Since it uses funds obtained from the financial market by way of loans, it is a deficit unit.

Ans iii.

Finance companies can facilitate Carson's expansion. Finance companies offer various services including loans and other products. Finance companies also help to find new investors or other companies to acquire, merge or sell. This can help Carson to obtain necessary funds to expand. If a finance company offers to acquire or merge with a new company, then Carson can start using assets of acquired company to expand business.

Ans iv.

Commercial banks can facilitate Carson's expansion. Commercial banks are those financial institutions which accept deposits, and offer loans to customers. They also involve in securitization. If a commercial bank agrees to provide new loans to Carson, or agrees to restructure it's debt, then Carson will have access to new and more funds. This will help in expanding business.

Ans v.

Carson may have limited access to debt during its growth phase. This is due to various reasons. Firstly, Carson already has substantial loans on its balance sheets. This means that there is low scope to get more loans. Secondly, with huge loans, the interest coverage ratio decreases. As a result, banks and finance companies might reduce access to debt or increase interest rates. Thirdly, the debt-equity ratio must remain favourable. In most cases, if the debt starts increasing, then it may hamper the value of the firm. This directly affects current shareholders. Therefore, it may not be able to obtain more debt.

Ans vi.

Carson can use primary market for its expansion. Carson is a large manufacturing company and has a good reputation. Carson also has assets worth of 50 million cedis. Therefore, if Carson decides to enter the primary market through an Initial Public Offer (IPO), they company will obtain good amount of cash in hand. This cash can be invested for expansion.

Ans vii.

Carson can use the secondary market. Since Carson is a large company, it has a good reputation. It also has high revenues. Therefore, if Carson issues bonds, it can enter the secondary market. Bonds are traded by bond holders in the secondary market. Bond financing may be a good option to raise money for financing the expansion.

Ans viii.

Carson will definitely be interested in future interest rate movements. As given in the case, Carson has a substantial debt, the interest rate to which is tied to the market interest rate. Also, Carson is looking to expand and it needs to finance the expansion. If the expansion is being financed by debt (for example through loans or bonds), then it is very important to remain informed about future interest rate movements. Lastly, interest rates, inflation and growth are closely linked. Interest rate movements are strong indicators to the performance of the economy. Carson would like to expand and for this reason, it is very important for Carson to know the performance of the economy.