Question

The Government of Ghana in an attempt to stimulate the Ghanaian economy after the COVID 19 pandemic has set aside GH¢600 million as a stimulus package for businesses. These stimulus packages are to be in the form of soft loans for businesses. However, some believe that these loans must be extended to firms in industries that are worst hit by the pandemic. As the Finance Director of your company, you have been tasked to present a proposal to the Board of Directors of your company for consideration. Your proposal must address the following;

i. The negative impact of the COVID 19 pandemic on the operations of your firm, justifying why your firm needs such a stimulus package? Your arguments should be situated within the industry within which you operate.

ii. With your understanding of lessons on capital structure, which other four (4) factors should your firm consider before choosing this source of debt finance?

iii. Discuss four (4) risks that your company is likely to be exposed to if it goes ahead with this source of debt finance.

iv. Explain how this decision will affect the return to the equity holders or shareholders of your company following the arguments of M&M proposition 2.

(Note:Your essay should not be more than 1500 words. Professional marks will be awarded for presentation)

Answer 1

i. Since the announcement of lockdown in March 2020, our company has undergone the following difficulties

• Zero revenues: Ever since the beginning of the lockdown, our company has not earned a single cedi in revenues. Apart from this, we have not been able to collect even 5% of our outstanding receivables. Since ours is a start up company and we have not raised even the first round of funding, we have been totally dependent on monthly revenues in order to meet expenses after investing/spending all the vapital brought in by promoters.
• Fixed expenses: The Board is aware that our company has to pay all its fixed costs on a monthly basis. These include rent, interest, salaries and electricity bills. Apart from these there are other smaller payments as well that need to be made periodically.
• Balance investment: In order to complete our ongoing projects, we need to invest another 5 million cedi. Under the present circumstances, we cannot raise this kind of money through equity which was proposed earlier.

In view of the above, it is proposed that our company utilise the stimulus package that is being offered by the Ghana Government which can be availed as a soft loan whose interest rate will be very much affordable to us and would not involve much documentation or long durations for sanction.

ii.Four factors to be considered while opting for debt:

1. Debt equity ratio post new debt
2. Interest service coverage ratio
3. Debt service coverage ratio
4. Payback period

iii.Four risks that the company could face if debt financed

1. Leverage issues: During good times and high demand scenarios, leverage is very good for all companies. However, in times of covid, this may not be the case and if revenues do not pick up, it will be difficult for the company to survive as there would not be enough revenues to pay off liabilites and expenses.
2. Interest burden: If the company does not make revenues quickly, the company will not be able to make cash profits and hence it may be difficult to service interest periodically.
3. Principal repayment:Inspite of the moratorium extended, there is an inherent risk that principal may not be repaid on time if business does not pick up.
4. Risk of promoters' future endeavours: If this debt is not repaid along with interest, promoters risk their prestige in the sense that further projects may be at stake.

iv.MM proposition 2 says that financial leverage is directly proportional to equity cost. Hence equity cost will go up since the shareholders will perceive the debt to be riskier to the company. So equity shareholders will expect additional returns thereby increasing the cost of equity.