ARG Co presently has $50m of fixed assets and long-term debt of $10m. The issue of $3m of 9% debentures will raise fixed assets by $2m of buildings and machinery. There appears to be ample security for the new issue. Interest cover is currently 5·1 (4560/900) which is less than the sector average and this will fall to 3·9 (4560/(900 + 3m × 9%)) following the debenture issue. The new products will enlarge profit by $440000 ($690000 - $250000 of depreciation) increasing interest cover to 4·3 (5000/1170). Although on the low side also less than the sector average this estimation ignores any increase in profits from current activities. Interest cover mayn't be a cause for concern.
Present gearing using debt/equity based on book values of 32% (10000/30900) will increase to 42% (13000/30900) after the debenture issue. Both values are below the sector average and ignore any increase in reserves due to next year's profits. Financial risk seems to be at an acceptable level and gearing doesn't appear to be a problem. The debentures are changeable after eight years into 20 ordinary shares per $100 debenture.
The current share price is $4·00 giving a conversion value of $80. For conversion to be probable a minimum annual growth rate of only 2·83% is needed ((5·00/4·00)0·125 - 1). This escalation rate could well be exceeded making conversion subsequent to eight years a likely prospect. This analysis presumes that the floor value on the conversion date is the par value of $100: the real floor value could well be different in eight years' time depending on the prevailing cost of debt.
Conversion of the debentures in to ordinary shares will eliminate the require to redeem them as well as reducing the company's gearing. The current share price possibly depressed by the ongoing recovery from the loss-making magazine publication venture. Annual share price growth may perhaps therefore be substantially in excess of 2·83% making the conversion terms too generous (presuming a floor value equal to par value on the conversion date). On conversion 600000 new shares will be issued representing 23% (100 × 0·6m/2·6m) of share capital. The company should seek the views and approval of existing shareholders regarding this potential dilution of ownership and control.
The maturity of the debentures (12 years) doesn't match the product life-cycle (four years). This perhaps cautions on the part of the company's managers but a shorter period could be used. It has been projected that $1 million of the debenture issue would be used to finance the working capital needs of the project. Funding all working capital from a long-term source is a very conservative approach to working capital financing. ARG Co may perhaps consider financing fluctuating current assets from a short-term source such as an overdraft. By involving the maturity of the finance to the maturity of the assets being financed ARG Co would be applying the matching principle.