Question 4
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Financial ManagementSubjectiveQuestion 5569 of 217
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Detailed Solution & Explanation
Part (a): Advantages and Disadvantages of Raising Finance by Issue of Debentures
Advantages of Debenture Financing:
1. Lower Cost of Capital: The cost of debentures is much lower than the cost of preference or equity capital because interest paid on debentures is tax-deductible. Additionally, investors perceive debenture investment as safer than equity or preference investments and, therefore, may accept a lower rate of return, further reducing the cost of financing.
2. No Dilution of Control: Debenture financing does not result in dilution of control because debenture holders are creditors, not shareholders. They do not carry voting rights, so the existing shareholders retain full management control of the company.
3. Advantage in Inflationary Periods: In a period of rising prices, debenture issue is advantageous. The company pays a fixed rate of interest, while the real value of this monetary outgo decreases as the price level increases — making the real burden of debt lighter over time.
Disadvantages of Debenture Financing:
1. Obligatory Fixed Payment: Debenture interest and the repayment of the principal amount at maturity are obligatory payments. Unlike dividends, interest must be paid regardless of the company's profitability, increasing the company's financial risk during lean periods.
2. Restrictive Covenants: The protective covenants associated with a debenture issue may be restrictive. Lenders often impose conditions relating to working capital maintenance, restrictions on further borrowing, or asset disposal, which can limit managerial flexibility.
3. Enhancement of Financial Risk: Debenture financing enhances the overall financial risk associated with the firm due to fixed interest obligations. If earnings are insufficient to cover interest, the firm faces serious financial distress.
4. Large Cash Outflow at Maturity: Since debentures must be repaid at the time of maturity, a large cash outflow is required at that specific point in time, which can strain the company's liquidity position.
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Part (b): Four Assumptions of Gordon's Model
Gordon's Dividend Capitalisation Model is built on the following key assumptions:
1. All-Equity Firm: The firm is an all-equity firm with no debt. There is no financial leverage, meaning the firm is entirely financed by equity.
2. Constant Internal Rate of Return (IRR): The IRR (r) of the firm's investments remains constant. A change in IRR would alter the growth rate and, consequently, the firm's value — so constancy of IRR is necessary for the model to hold.
3. Constant Cost of Equity (Ke): The cost of equity (Ke) remains constant. Since Ke is used to discount future dividends, any change in it would directly affect the present value of dividends and hence the share price.
4. Constant Retention Ratio (b): Once decided upon, the retention ratio (b) — and correspondingly the dividend payout ratio — remains constant throughout the life of the firm.
5. Constant Growth Rate (g = b \u00d7 r): The growth rate g = b \u00d7 r is constant, because both the retention ratio (b) and the IRR (r) remain unchanged, keeping the growth rate steady.
6. Ke > g: The cost of equity must be greater than the growth rate (Ke > g). This assumption is necessary based on the principle of the sum of an infinite geometric progression; otherwise, the model would yield an infinite share value.
7. No External Financing: All investment proposals of the firm are financed through retained earnings only. No external financing (debt or new equity) is used.
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Part (c): Leveraged Lease
A Leveraged Lease is a special type of leasing arrangement that involves three parties: the lessor, the lessee, and a third-party lender (financier).
Under this arrangement:
\u2022 The lessor borrows a substantial portion (e.g., 80%) of the purchase cost of the asset from a third-party lender, while the remaining portion (e.g., 20%) is contributed by the lessor himself.
\u2022 The asset so purchased is held as security against the loan from the lender.
\u2022 The lessee pays lease rentals, which are used directly to repay the lender. The surplus after meeting the lender's claims goes to the lessor.
\u2022 The lessor is entitled to claim depreciation allowance on the asset.
In essence, the lessor acts as the owner-operator with significant leverage from borrowed funds, hence the term 'leveraged lease.' This structure is common in large-ticket financing such as aircraft, ships, or industrial machinery.
---
Part (d) [OR]: Remedies for Over-Capitalisation
Over-capitalisation occurs when a company has more capital than it can profitably employ, resulting in lower earnings per share and reduced market value. The following remedies may be adopted:
1. Thorough Reorganisation: The company should undergo comprehensive financial and operational reorganisation to bring the capital structure in line with actual earning capacity.
2. Buyback of Shares: The company may repurchase its own shares from the market to reduce the surplus capital, thereby improving earnings per share and restoring shareholder value.
3. Reduction in Claims of Debenture-Holders and Creditors: Negotiating a reduction in the outstanding obligations to creditors and debenture holders can help reduce the burden of over-capitalisation.
4. Reduction in Value of Shares: The par value or paid-up value of shares may be reduced. This frees up retained surplus funds that can then be used for replacement of assets and productive reinvestment, restoring the earning power of the company.
Advantages of Debenture Financing:
1. Lower Cost of Capital: The cost of debentures is much lower than the cost of preference or equity capital because interest paid on debentures is tax-deductible. Additionally, investors perceive debenture investment as safer than equity or preference investments and, therefore, may accept a lower rate of return, further reducing the cost of financing.
2. No Dilution of Control: Debenture financing does not result in dilution of control because debenture holders are creditors, not shareholders. They do not carry voting rights, so the existing shareholders retain full management control of the company.
3. Advantage in Inflationary Periods: In a period of rising prices, debenture issue is advantageous. The company pays a fixed rate of interest, while the real value of this monetary outgo decreases as the price level increases — making the real burden of debt lighter over time.
Disadvantages of Debenture Financing:
1. Obligatory Fixed Payment: Debenture interest and the repayment of the principal amount at maturity are obligatory payments. Unlike dividends, interest must be paid regardless of the company's profitability, increasing the company's financial risk during lean periods.
2. Restrictive Covenants: The protective covenants associated with a debenture issue may be restrictive. Lenders often impose conditions relating to working capital maintenance, restrictions on further borrowing, or asset disposal, which can limit managerial flexibility.
3. Enhancement of Financial Risk: Debenture financing enhances the overall financial risk associated with the firm due to fixed interest obligations. If earnings are insufficient to cover interest, the firm faces serious financial distress.
4. Large Cash Outflow at Maturity: Since debentures must be repaid at the time of maturity, a large cash outflow is required at that specific point in time, which can strain the company's liquidity position.
---
Part (b): Four Assumptions of Gordon's Model
Gordon's Dividend Capitalisation Model is built on the following key assumptions:
1. All-Equity Firm: The firm is an all-equity firm with no debt. There is no financial leverage, meaning the firm is entirely financed by equity.
2. Constant Internal Rate of Return (IRR): The IRR (r) of the firm's investments remains constant. A change in IRR would alter the growth rate and, consequently, the firm's value — so constancy of IRR is necessary for the model to hold.
3. Constant Cost of Equity (Ke): The cost of equity (Ke) remains constant. Since Ke is used to discount future dividends, any change in it would directly affect the present value of dividends and hence the share price.
4. Constant Retention Ratio (b): Once decided upon, the retention ratio (b) — and correspondingly the dividend payout ratio — remains constant throughout the life of the firm.
5. Constant Growth Rate (g = b \u00d7 r): The growth rate g = b \u00d7 r is constant, because both the retention ratio (b) and the IRR (r) remain unchanged, keeping the growth rate steady.
6. Ke > g: The cost of equity must be greater than the growth rate (Ke > g). This assumption is necessary based on the principle of the sum of an infinite geometric progression; otherwise, the model would yield an infinite share value.
7. No External Financing: All investment proposals of the firm are financed through retained earnings only. No external financing (debt or new equity) is used.
---
Part (c): Leveraged Lease
A Leveraged Lease is a special type of leasing arrangement that involves three parties: the lessor, the lessee, and a third-party lender (financier).
Under this arrangement:
\u2022 The lessor borrows a substantial portion (e.g., 80%) of the purchase cost of the asset from a third-party lender, while the remaining portion (e.g., 20%) is contributed by the lessor himself.
\u2022 The asset so purchased is held as security against the loan from the lender.
\u2022 The lessee pays lease rentals, which are used directly to repay the lender. The surplus after meeting the lender's claims goes to the lessor.
\u2022 The lessor is entitled to claim depreciation allowance on the asset.
In essence, the lessor acts as the owner-operator with significant leverage from borrowed funds, hence the term 'leveraged lease.' This structure is common in large-ticket financing such as aircraft, ships, or industrial machinery.
---
Part (d) [OR]: Remedies for Over-Capitalisation
Over-capitalisation occurs when a company has more capital than it can profitably employ, resulting in lower earnings per share and reduced market value. The following remedies may be adopted:
1. Thorough Reorganisation: The company should undergo comprehensive financial and operational reorganisation to bring the capital structure in line with actual earning capacity.
2. Buyback of Shares: The company may repurchase its own shares from the market to reduce the surplus capital, thereby improving earnings per share and restoring shareholder value.
3. Reduction in Claims of Debenture-Holders and Creditors: Negotiating a reduction in the outstanding obligations to creditors and debenture holders can help reduce the burden of over-capitalisation.
4. Reduction in Value of Shares: The par value or paid-up value of shares may be reduced. This frees up retained surplus funds that can then be used for replacement of assets and productive reinvestment, restoring the earning power of the company.
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