Merit Enterprise Corp. Sara Lehn, chief financial officer of Merit Enterprise Co
ID: 2724173 • Letter: M
Question
Merit Enterprise Corp.
Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her presentation one last time before her upcoming meeting with the board of direc- tors. Merit’s business had been brisk for the last two years, and the company’s CEO was pushing for a dramatic expansion of Merit’s production capacity. Executing the CEO’s plans would require $4 billion in capital in addition to $2 billion in excess cash that the firm had built up. Sara’s immediate task was to brief the board on options for raising the needed $4 billion.
Unlike most companies its size, Merit had maintained its status as a private company, financing its growth by reinvesting profits and, when necessary, borrowing from banks. Whether Merit could follow that same strategy to raise the $4 billion necessary to expand at the pace envisioned by the firm’s CEO was uncertain, though it seemed unlikely to Sara. She had identified two options for the board to consider:
Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit well for many years with seasonal credit lines as well as medium-term loans. Lehn believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own, but it could probably gather a group of banks together to make a loan of this magni- tude. However, the banks would undoubtedly demand that Merit limit further bor- rowing and provide JPMorgan with periodic financial disclosures so that they could monitor Merit’s financial condition as it expanded its operations.
Option 2: Merit could convert to public ownership, issuing stock to the public in the primary market. With Merit’s excellent financial performance in recent years, Sara thought that its stock could command a high price in the market and that many investors would want to participate in any stock offering that Merit conducted.
Becoming a public company would also allow Merit, for the first time, to offer employees compensation in the form of stock or stock options, thereby creating stronger incentives for employees to help the firm succeed. On the other hand, Sara knew that public companies faced extensive disclosure requirements and other regu- lations that Merit had never had to confront as a private firm. Furthermore, with stock trading in the secondary market, who knew what kind of individuals or insti- tutions might wind up holding a large chunk of Merit stock?
TO DO
a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the most positive aspects of this option, and what are the biggest drawbacks?
b. Dothesameforoption2.
c. Which option do you think Sara should recommend to the board and why?
Explanation / Answer
a) Option 1: raising capital through debt:
Pros:
1. No sharing of profits and control
2. Cost of debt is generally lower than cost of equity. So, low cost of capital
3. No public scrutiny of financials
4. Higher valuation of the firm due to likely existance of corporate tax as per MM model
Cons:
1. High debt will eat into operating profit and make the net profit much low
2. The repayment becomes a fixed obligation during the tenure. It increases risk of bankcrupcy.
3. Since, the expansion plan is aggressive, there is inherent risk associated with it being financed through debt. If due to any internal or external factor sales doesn't increase as projected, the company will face severe financial distress.
4. Banks may put strict riders for the usage of the lent money and significantly restrict management's freedom in allocating the funds.
b) Option 2: raising capital through equity
Pros:
1. The raised capital will stay forever (unless company is liquidated) and no constant obligation of repayment
2. Freedom of usage of the raised capital
3. Even if there is a downturn, chances of financial distress is low
4. Higher net profit margin due to absence of interest payment
Cons:
1. Extensive disclosures and public scrutiny of finacial and ativities inside the company which management may not be comfortable with
2. Equity is a costlier source of capital than debt
c) It is already given that the expansion plan is aggressive. It is so risky that no bank would individually take the whole exposure. It would not be prudent to fund this expansion through debt. Many high flying companies crash financially because their aggressive management take debt that they can't serve due to lack of sales and the factors are often beyond their control.
On the other hand, if the fund is raised though equity, in case of a downturn the investors may not get good returns but there is far less risk of the company get chocked. Additionally, the company has a good track to command a high valuation from equity investors. Therefore, Sara should recommend the second option.
3.