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FIN3101 Case 3
Transcript of FIN3101 Case 3
The growth of their stock is heavily relying on borrowing money, which is not sustainable. Average IPO expense ratio in Hong Kong is 10% - 20% Wei has been considering IPO as a source of financing since 2003.
There were some other financing alternatives. Fu Ji Food and Catering Company Introduction Dividends Policy Financing Decision in 2006 Fu Ji 3 batches of CB &
its financial distress 1999: First Fu Ji restaurant was founded by Weidong and Yao Juan in Suzhou
2002: Fu Ji stepped into the undeveloped institutional catering food market
2004: Fu Ji was listed on Hong Kong Stock Exchange
2005-2007: Fu Ji issued its 3 rounds of CB2010,CB2009 and CB2010' respectively
2005-1st half 2008: Fu Ji carried out excessive expansion
2nd half 2008 onward: Fu Ji fell into financial distress and its stock being suspended UBS's Proposals Pecking Order or Not? IPO 2004 - Fu Ji was still in fast expansion
- Capital gain was high enough to offset zero dividends payment
- Fu Ji should retain most of its earnings to finance future growth instead of maintaining a constant dividend policy from 2006
- When the growth rate decreased and the company reached a mature state, the company will start to pay out dividends to ensure investors’ return Group 3A
Zhong Liang extremely successful:
huge amount of money is raised, while a heavy debt burden is avoided;
13.3% of cost saving is realized through CB, compared with direct issue of shares
Helping Fu Ji to raise large amount of cash for expansion need, without introducing as heavy a debt pressure as expected.
Final conclusion still depends on whether the Fu Ji stock will continue this booming trend .
If stock price keeps increasing, more CB2009 holders will choose to convert their bonds, releasing Fu Ji from a heavy debt pressure.
If the stock price behaves unsatisfied, Fu Ji would possibly fell into financial pressure afterwards. Fu Ji got into a vicious loop:
as the maturity day getting closer and its stock price getting lower, the less likely these CB to be converted, and Fu Ji will have more financial pressure to pay for these debts, thus less favorable Fu Ji's stock will be, and consequently, Fu Ji stock price will be even lower.
Subsequently in 2008, international financial crisis kicks in, Hong Kong stocks price fell comprehensively.
Fu Ji stock fell from nearly HK$29.20 down to HK$2.27. It became almost impossible for these CB to be converted. Fu Ji stock eventually became precarious, which led to the Fu Ji’s financial distress and shares suspended from trading in 2009. 2005 2006 2007 Alternatives IPO Pricing Expenses Bank Loans Bonds Equity Issue Issue New Convertible Bonds Internal
Placement Bank Loans IPO
Financial Resource Alternatives
IPO Pricing Analysis
IPO Expenses Fu Ji's IPO Analysis Capital Structure
Business Model in terms of sustainable growth
Facing UBS' proposal in 2006 Company Analysis Internal
Financing Reach out to high net worth individuals - Provide Fu Ji the large amount of capital it needed.
- Good market trend
Hong Kong stock market was
Fu Ji’s share price was forecasted to grow fast as both the firm and the market grew.
In 2004, the average capital raised through IPOs in Hong Kong was HK$692.29 million.
- Future funding sources
Seasoned equity offering (SEO). SEO usually raised three times the capital of IPO.
- Create a good image 2. Growing sales and profit margin Launch IPO in 2004, followed by issuing convertible debt in 2005 to 2007. It preferred financing through equity and debt to retained earnings. Gross Proceeds: HK$3.10*100,000,000=HK$310 million
Estimated Expenses: HK$22 million
Net proceeds: HK$310 - HK$22 = HK$288 million
Expense Ratio = HK$22 million / HK$310 million = 7.10% 17 Dec 2004 in Hong Kong
Offering price: HK$3.10
First day closing price: HK$3.62
Initial return 17%
Raised about HK$324.6 million
Investors' capital gain: 139% by Sep 2005
Fu Ji’s capacity: increased to 8.7 times by Nov 2005 - IPO is usually underpriced
- The average initial return of IPO in Hong Kong is the lowest among the three regions.
- However, though Hong Kong did not have the highest initial return on IPO, it did raise the highest average capital on IPO in 2004 3. Comparison with Ajisen Ramen and Little Sheep Dividend yield in 2006 Fu Ji's Dividends Payments - Asymmetric information
- Chooses to finance its investment activities using retained earnings first, followed by issuing debt and lastly through equity. Pecking Order Retained profit Growing rapidly from 2002 to 2004 IPO and CB Comparison with Ajisen Ramen and Little Sheep - Will not dilute ownership
- Will not increase D/E ratio
- No interest cost Used to be one of Fu Ji’s major sources of capital - Costly:
benchmark interest rate:
5.76% for 1 to 3 year loans
5.85% for 3 to 5 year loans
- Not enough collateral assets Convertible bonds: - Attractive to investors
- Low interest
- May not need to pay back - Possibility of diluted shares in the future - Improve D/E ratio
- Less expensive compared with public offering Pros: - May not have access to such individuals
- Endanger Wei’s ownership and controlship
- Share profit with others Cons: Pros: Cons: - Small revenue not enough to support large investment requirements
- Decreases liquidity, may not be able to cover daily expenses - Dilute Wei’s ownership
Fu Ji planned to issue 100,000,000 new shares which amounted to 1/4 its total shares outstanding.
- Share its growth and profit with public shareholders
Not preferable for a fast growing firm
- High cost
Estimated IPO expenses to be HK$22 million, which was 7.10% its gross proceedings.
High maintenance cost
- Fu Ji had to abide to the listing requirements in Hong Kong. Pros: Cons: Win-Win Situation Financial Distress in 2009 A Total Failure Fu Ji lacks a moderate risk & liquidity management system.
Fu Ji management is overconfident and too optimistic about debts. Stock market downturn in 2008. Fu Ji fell into the financial scandal of cheating in their annual financial statements. Subsequently, its chief financial officer announced his resignation. The entire Fu Ji fell into serious panic.
Fu Ji lost their major contract with the China EMU (Fast Train Operator), due to a decreasing service level. Business Model Financing Needs Financial Status Three Options Equity issue
New convertible bonds
Bank loans Business Model Compete in highly fragmented market manages raw material costs & quality
reduces uncertainty in supply chain and distribution channel
economies of scale Vertical Integration Model High demand for capital investment Acquisition of other businesses
Capital outlays in new business lines: constructions, working capital VS. Financing Needs Trend: growth rates of working capital items from 2004 - 2006
Estimate growth rates of working capital items for 2007 - 2010
Assumptions: constant growth rates, increasing growth rates, decreasing growth rates (Scenario test)
Estimate level of working capital items for 2007 - 2010
Estimate changes in net working capital and total needs Trend: Growth Rates from 2004 - 2006 Projection with constant growth rates Scenario tests Projection vs. Actual growth rates increases/decreases 0.2% every year
Actual changes in working capital does not follow the trend Estimated funding needs is close to the actual figure - Basic EPS on 31 March 2004: RMB27.5 cents = 27.5/1.0633 = HK$25.86 cents
- P/E before IPO = HK$3.10 / HK$25.86 cents = 11.99 Financial Status Financial leverage Liquidity Profitability & operations Debt: - Will not dilute ownership
- Tax shield - Lead to high D/E ratio
likely financial distress
Fu Ji’s D/E ratio had been much higher than industry average of 40% to 60%
Financing through debt will increase the D/E ratio to 2.1 Pros Cons general trends of enhanced ability to meet current liabilities
may lead to illusion of confidence Pros: Cons: Total debt ratio decreases over time
due to fast expansion
Long-term-debt-to-equity: low, but shows signs of increase
TIE ratio decreases -> ability to meet debt obligations deteriorates IPO Pecking Order Profitability declines around 2004
Sales growth drops after 2004
ROE, ROA drops faster after 2004
Operations is less efficient in 2006
Tax has been reduced after 2003
Nevertheless, profit margins decreases Good liquidity and reasonable leverage level
may lead to over-confidence about future performance
Declining profitability and operational efficiency
should be alerted of the trend and future performance -> avoid over-optimism
investigate the reasons and avoid continuation of the trend Fu Ji should avoid risky capital structure Issue Straight Equity Pros Asian stock market's recovery from meltdown
Good signs of Heng Seng Index
Good performance of Fu Ji's IPO
No obligation to pay interest Cons Immediate dilution of ownership
Fu Ji's share price is relatively undervalued compared to peer companies
Unpredictable investor reaction
Fu Ji's IPO expense ratio is higher than interest rate New Convertible Bonds Pros More likely to raise the full amount needed
conversion option protects investors
Deferred dilution of ownership
Slightly lower coupon rate than normal bonds
Principal can be reduced when bondholders choose to convert Cons Bet on company's future performance and future share price
Increase financial leverage and company's risk Bank Loans Pros
Interest payment will have interest tax shield
No ownership dilutions Cons More expensive than CBs
6.5% vs. 5.75%
Complex application procedure and documents
May not be granted the amount needed
Fu Ji already has over 200 million bank loans
Increase financial leverage Financing Decision Other potential options: "Angel funds"
takes time, not easy to find
provide funds in exchange for ownership -> against management's goal New Convertible Bonds Share Issue/
Bank Loans Deferred ownership dilution
Management team's confidence in the company Dilution of Ownership Assuming the new shares are issued at current share price.
Exchange rate 8/31/2006:
HKD/CNY = 1.02208
HK$12.22 = RMB 11.96
New shares to be issued:
947,000,000 / 11.96 = 79,180,602 shares Conversion premium = 32%
Share price = HK$12.22
Conversion price = 12.22 × (1+32%) = HK$16.13
Assume all holders of new CBs will convert CBs to shares:
HK$16.13 = RMB 15.78
Shares created by conversion:
947,000,000 / 15.78 = 60,012,647 shares Equity Issue New Convertible Bonds Conversion Premium Size-weighed average is 34.7%
5 out of 6 have put option
Assume conversion premium for Fu Ji's CB without put option is slightly lower: 32% Undervalued Relative to Peer Companies Partially successful at the current stage: industry DE ratio average: 40%-60% Current Situation of Fu Ji The Wei's family announced their resignations and eventually sold their 53% of Fu Ji stocks to Anhui Conch Venture Capital Co. Ltd., who has no previous experience in food industry.
Anhui Conch Venture agreed to pay RMB 600 million as the total cost for their restructuring proposal.
Fu Ji stock will continue to be suspended for further instructions. Thank you!
Q & A Estimated: Actual: Gross proceeds: HK$3.10 * 115,000,000 = HK$356.5 million
Net proceeds: HK$324.6 million
Expense: HK$356.5 million - HK$324.6 million = HK$31.9 million
Expense ratio: HK$31.9 million / HK$356.5 million = 8.95% Shares were over-subscribed by 15%, giving a total number of shares of 115,000,000 Fu Ji's actual expense ratio: 8.95% Dividend policy changed after IPO Not appropriate to finance fast expansion Bank loans
Bonds Private placement
Internal financing. % of Sales Approach Assume inventory, receivables and payables follow the trend in their percentage of sales in 2004 - 2006
Use projected sales for 2007 - 2010 as the base What happened in reality... - Fu Ji's initial day return was slightly above average of Hong Kong market
- Its P/E ratio was much less than competitors on IPO day, and increased fast after IPO
- Over-subscription It was reasonably priced, though shares with a higher IPO price might also be fully subscribed and raise more capital 4. Over-subscribed by more than 10 times - 10,000,000 Public Offer Shares were over-subscribed by about 41.1 times
- 90,000,000 Placing Shares were over-subscribed by 6.7 times - P/E increased to 27.1 in 2006, which was more reasonable than P/E at IPO Fu Ji's initial return on IPO was 17%, among the average in Hong Kong 1. Initial Day Return Fu Ji raised HK$324.1 million, half of the average in Hong Kong US$89 million = HK$692.29 million Conclusion Stock performance of Fu JI Beta (Exhibit 7): 0.69
Risk free rate (yield of 10-year Hong Kong government bond in 2006): 4.2%
Market risk premium (Hong Kong equity market risk premium): 6.0%
Required return on Fu Ji stock = 4.2% + 0.69 * 6% = 8.34% Compound annual growth of Fu Ji’s shares = (HK$12.22/HK$3.10)^1/1.67-1 = 127.36%.