Merit Enterprise Corp. Sara Lehn, chief financial officer of Merit Enterprise Co
ID: 2736438 • 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 directors.
Merit’s business had been brisk for the last 2 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,
although it seemed unlikely to Sara. She had identified the following 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 magnitude.
However, the banks would undoubtedly demand that Merit limit further borrowing
and provide JPMorgan with periodic financial disclosures so that it could
monitor Merit’s financial condition as Merit 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 regulations
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 institutions
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. Do the same for option 2.
c. Which option do you think that Sara should recommend to the board, and why?
Explanation / Answer
Answer:a The first option Sara Lehn considers when asked to raise the $4 billion needed for the dramatic expansion planned by the CEO, is borrowing the money from JPMorgan Chase, a bank they have previously made business with. One problem could be that this time the amount is much bigger comparing to the seasonal credit lines and medium term loans made before.
One important drawback of borrowing from banks is the covenant that banks impose on companies to which they lent money. Covenants are rules placed on debt that are designed to stabilize corporate performance and reduce the risk a bank is exposed when giving a large amount of money to a company.Examples of covenants may be: cannot issue any more debt until the loan is completely paid off; can not participate in any share offerings until the loan is paid off, etc. covenants can be very straight forwardand sometimes difficult to deal with.
Another drawback is that the company will have to pay interest annually plus the repayment of the principle.
The most positive aspect of this option is that debts can often work as tax shields. Interest paid on debt is a tax-deductible expense, so the company could save some money by financing with debt instead of going public. The investment the company wants to make is big and the interest will also be pretty big.Therefore, the deduction in taxes will also be pretty high, saving the company from paying so much money.
Another positive aspect is that the company will not have to search in many places to find investors. It will only go to the bank, and the employees working there will take care to raise the money needed and give it to the company. So, the company will not have to contact third parties that may even be risky and jeopardize the plans of the firm.
Answer:b Sara’s second option is to transform the company in a public one. The positive aspects of this option are that Merit Enterprise had an excellent financial performance in the last years so probably manypowerful investors will be interested to buy the stock and the stock could command a high price on themarket.
The second positive aspect is that for the first time the company offer to employees a compensation in stock or stock options
.Another advantage is that going public generates publicity and increases awareness of the company and attracts new customers.Stock Value Appreciation If your public company performs well,the value its stock tends to increase.This is one of the foremost reasons to Go Public, the future value of the company stock.
Retain Control-In most cases, Venture Capital investors will want to appoint someone on their team as a member of the board of directors. Moreover, they usually want to have more than half of the ownership and/or voting rights. Through the public equities market, or going public, you can maintain control.
Liquid Equity-When you take your company public, your shares can be used as or turned into cash, for paying debts, acquiring another business, etc.
Control Risk-If you ever feel that your shares will drop in price, you could sell them. Naturally, proper public disclosures are required. Publicly traded shares are much easier to sell quickly than are privatelyheld ones.
The biggest drawbacks in this case are extensive disclosure requirements for investors and the problem that on the secondary market any kind of individuals or institutions might wind up holding a large chunk of Merit stock.
Public companies also are faced with the added pressure of the market which may cause them to focusmore on short-term results rather than long-term growth. The actions of the company's management also become increasingly scrutinized as investors constantly look for rising profits. This may lead management to perform somewhat questionable practices in order to boost earnings.
Answer:c I think Sara should recommend option 2 to the board; as the company is on a growth trajectory there could be continuous demand for funds which cannot be met by retained earnings and debt alone,therefore keeping the future in perspective equity issue will be a good decision.
The final objective of any company is to improve performance, growth and shareholder wealth which can be met by growing in size unless these objectives are replaced by management control as a private company will have a growth limited by the funds available for investment.
Though cost of equity is high there are no fixed financial payments linked to it.
Even though Merit will require larger financial and other disclosures, this will only bring in more transparency and better corporate governance in the company.
Though both equity and debt have their pros and cons, an equity issue also increases the debt capacity of the firm as the firm can resort to higher debt in future.Today we are in a global market competing not just with local peers but also internationals, therefore going public gives better visibility, brand image, larger investor base and recognition.