Question

Ragan, Inc. was founded nineteen years ago by brother and sister Carrington and Genevieve Ragan. The company manufactures and installs commercial heating, ventilation, and cooling (HVAC) units. Ragan, Inc. has experienced rapid growth because of a proprietary technology that increases the energy efficiency of its units. The company is equally split between the two siblings. The original partnership agreement between them gave each 500,000 shares of stock. The company has since gone public. At that time, the siblings retained their shares and 1,000,000 shares of new stock were issued.

The firm anticipates needing to raise a large amount of capital ($10 million) in the coming year to facilitate further expansion and are evaluating several financing options. The first option is to issue zero-coupon bonds that mature in 20 years. Similar zero-coupon bonds currently have a YTM of 4.5%. The second option is to issue 4% coupon bonds that mature in 20 years. Similar bonds have a YTM of 4%. The third option is to issue preferred stock with a fixed dividend of $0.85 per share. These preferred stock would have a required return of 7.5%. The firm currently has no preferred stock outstanding. The fourth option is to issue common stock.

The stock is currently trading on the market for $20 per share. The firm most recently paid a dividend on common stock of $0.50 and plans to increase that dividend by 25% per year for the next five years. After that, the firm will level off at the industry average of 5% per year, indefinitely. Carrington and Genevieve estimate the required return on the stock to be 15%.

1. What additional (qualitative) considerations must be made with respect to issuing common stock? How might existing shareholders feel about this?

2. Are there any additional factors you believe should be considered? If so, what are they and how might they impact your recommendation?

Answer 1

The company should keep the one more scenario in mind - Bankruptsy. The obligation to common stock holders is the least in case the company becomes financially distressed.

The company increases the outstanding shares by selling additional common shares in the financial market. Hence, diluting the existing shareholders' ownership. It also diminishes the existing shareholders' stake and voting influence.

Issuing common stock although is a less expensive route to get funded as compared to other debt intruments. The interest payment obligations are spared and dividends can be paid if there is extra cash in company.

The most important implication of issuing stock is that the company secure access to the cash which need not be paid back, hence, giving breathing space and flexibility to perform its operations.

Issuing stocks as compared to the bonds are generally issued only once as the value of share decreases due to extra supply. Whereas bonds can be issued n number of times.