Question

Overview

Communication is critical in accounting. It's not just enough to be able to calculate the numbers and know what to debit and credit - you must be able to communicate what the information means to non-accountants. In this Module 2 Case, you'll be asked to synthesize your knowledge about raising capital with debt versus equity in a corporation and clearly and concisely express your thoughts in writing. If you are unfamiliar with writing business oriented documents, Purdue Online Writing Lab is one of many good resources available.

Instructions

Zeller & Merkel, Inc. (ZM) is a mid-sized high-tech manufacturing firm that has taken you on as an intern. You are very thankful for this opportunity, especially as Tim Zeller and Christine Merkel are known for giving their interns opportunities to use their accounting knowledge by asking for the student’s evaluation of important scenarios in a live business. A good example is ZM’s current plan to raise money through a stock issue rather than a debt issue. You recall from your Intermediate Accounting class that issuing debt imposes a fixed financial obligation on the company, but does not convey ownership to the debt holders. However, if ZM issues stock, it gives up some ownership and thus some control. You know Zeller and Merkel are protective of the company, and you wonder why they would choose to issue stock. You decide to ask them the next day.

ZM is very receptive of your inquiry, and they invite you to give your evaluation and opinion on the following 5 scenarios they have been considering for raising the necessary money for expansion:

1. Issue $10,000,000 of 10-year bonds with a coupon rate of 4%, interest payable semiannually. Although the current market rate is 4%, based on current economic forecasts, Zeller and Merkel recognize that market rates might increase to 6% by the time they issue the bonds. Although they do not like the option of added debt, they feel it is a reasonable alternative and should beconsidered. However, they are not clear on the implications that this bond issue would have on the company and its financial statements, including the impact of the possibility that interest rates might increase by the time the bonds could be actually issued.

2. Zeller and Merkel do realize that they could also outright borrow the $10,000,000 from a financial institution, but again are unclear as to the impact on the financial statements. In addition to describing that impact, they also ask you to compare the advantages and disadvantages of raising the monies via a bond issue versus a loan

3. A  third possibility is to issue 2,600,000 shares of common stock ($2 par value) to current shareholders and a selected group of new investors (a private issue). They have been advised to price the stock to sell at ZM^’s book value per share at the end of 2017. In addition to wanting to know the advantages and disadvantages of using this private issue to raise capital, they also ask you to clarify what is meant by “book value per share” and what implications that would have on this scenario.

4. The company does have some shares held in the treasury, and they wonder if that might be another viable alternative to raising the needed funds. Zeller and Merkel are curious to see if you know what impact this alternative would have on the company and its financials.

5.The fifth option is to proceed with an initial public offering (IPO). Based on current and anticipated economic conditions, the resurgence of the IPO market, and interest in high-tech companies, Zeller and Merkel think they could get an IPO price of around $5 per share. At this price, they would need to issue approximately 2,000,000 shares.

Prepare a detailed and thorough business memo in good business format describing the advantages and disadvantages of each scenario described above. Keep in mind that you are writing to entrepreneurs, not accountants. Which alternative would you recommend and why? Be sure to justify your answer by comparing the merits of raising capital through bonds, loans, and common stock. Keep in mind that you will need to document your memo with properly cited references as to the sources of any outside information as Zeller and Merkel will want to know the source of the information.

Answer 1

Scenario 1: Issue of 4% Bond
Implications:
Advantages:
1. Debt will increase which will increase the debt Equity Ratio
2. Interest payment will increase tax benefit as interest is tax deductible
Disadvantages:
1. Fix cash outflow in form of Interest, failure of which will affect its credit rating
Scenario 2: Loan From Financial Institution
Loan Amount	10000000
Advantages:
1. Debt will increase which will increase the debt Equity Ratio
2. Interest payment will increase tax benefit as interest is tax deductible
Disadvantages:
1. Fix cash outflow in form of Interest, failure of which will affect its credit rating
2.Interest Rate is normally higher for financial institution, interest exp will be higher
Scenario 3: Common Stock Issuance
Advantages:
1. No fixed Interest Expenses will be incurred , better cashflow
2. Debt Equity ratio will be strong , as equity will be on higher side
Disadvantages:
1. Control will be reduced as new investors will come
2. Tax Expenses will increse as leverage of using debt will not be there.
Book Value per share	(Total share capital of the company + reserves & Surplus )/ No of shares outstanding
Book value basically shows the value of the shares and the retained earning combined together as shown in the financial statements
Scenario 4: Shares held on treasury
Advantages:
1. Neutral cash flow due to No Interest expenses as well as no dividend income from shares held
Disadvantages :
1. loss of income from investments
2. Tax Expenses will increse as leverage of using debt will not be there.
Scenario 5: IPO
Advantages:
1. Increase cash flow due to issue of shares at premium
2. Better debt equity ratio due to increase in Equity capital and reserve & surplus
Disadvantages:
1. Control will be reduced as new investors will come
2. Tax Expenses will increse as leverage of using debt will not be there.
The optimum option will be IPO, Because of the following
1. Increase in Reserve - Share issued at premium
2. Ownership/ loss of control to the extent of 20 Lac shares (26 lac share in case of Private Issue)
3. Dividend will be on $40 lac (i.e. Face Value), in other cases any dividend / Interest Exp will be on $100 Lac
4. No risk for credit rating due to fixed obligation defaults
5. Strong debt equity ratio & solvency ratio