Question

Ragan, Inc. was founded nineteen years ago by brother and sister Carrington and Genevieve Ragan. The

company manufactures and installs commercial heating, ventilation, and cooling (HVAC) units. Ragan,

Inc. has experienced rapid growth because of a proprietary technology that increases the energy

efficiency of its units. The company is equally split between the two siblings. The original partnership

agreement between them gave each 500,000 shares of stock. The company has since gone public. At

that time, the siblings retained their shares and 1,000,000 shares of new stock were issued.

The firm anticipates needing to raise a large amount of capital ($10 million) in the coming year to

facilitate further expansion and are evaluating several financing options. The first option is to issue

zero-coupon bonds that mature in 20 years. Similar zero-coupon bonds currently have a YTM of 4.5%.

The second option is to issue 4% coupon bonds that mature in 20 years. Similar bonds have a YTM of

4%. The third option is to issue preferred stock with a fixed dividend of $0.85 per share. These

preferred stock would have a required return of 7.5%. The firm currently has no preferred stock

outstanding. The fourth option is to issue common stock.

The stock is currently trading on the market for $20 per share. The firm most recently paid a dividend

on common stock of $0.50 and plans to increase that dividend by 25% per year for the next five years.

After that, the firm will level off at the industry average of 5% per year, indefinitely. Carrington and

Genevieve estimate the required return on the stock to be 15%.

1. The firm already has some public bonds outstanding. Those bondholders may not be

comfortable with the idea of issuing new bonds. How might the firm reassure existing

bondholders?

2. What additional (qualitative) considerations must be made with respect to issuing preferred

stock? How might existing shareholders feel about this?

3. Are there any additional factors you believe should be considered? If so, what are they and how

might they impact your recommendation?

Answer 1

1. Although the company already has bonds outstanding, the company may prefer to go for further issuance of new bonds because bonds will not dilute the ownership stake and participation in the company. As far as existing bondholders are concerned, the company may assure such bondholderes that issuance of new bonds will not affect the payment of regular returns to them since the company has enough cash to pay them off. Apart from that, the company may also show them that the company is growing at a very good pace thus new bonds will not affect their returns but contribute to the growth and development of the company.

2. Preferred stock is an optimal alternative for risk averse equity investors. These stocks are typicall less volatile than the common stock and offer a steadier flow of returns. Also these are callable, that is the issuer may redeem them at any time providing more options to the investors.

The existing common stock holders may not feel good because preferred stock will get the preference of the dividend and repayment over the common stock which may instill a feeling of insecurity among the common stock holders. In such a situation, the company has to give confidence to the common stock holders by showing them the future growth prospects of the company.

3. The additional factors which are required to be considered are:

a. Cost of funds

b. Risk attached to the various options

c. Dilution of the ownership

d. Feeling of the existing stock and bond holders

e. Cash availability in the future