Gonzales Food Stores, a family-owned grocery store chain headquartered in El Paso, has hired you to make recommendations concerning financing needs for the following two situations.
Part I: Initial Expansion Gonzales is a closely held corporation considering a major expansion. The proposed expansion would require the firm to raise $10 million in additional capital. Because Gonzales currently has 50 percent debt and because the family members already have all their funds tied up in the business, the owners cannot supply any additional equity, so the company will have to sell stock to the public. The family wants to ensure that it will retain control of the company. This offering would be Gonzales’s first stock sale, and the owners are not sure exactly what would be involved. For this reason, they have asked you to research the process and to help them decide how to raise the needed capital. In doing so, you should answer the following questions:
a. What are the advantages to Gonzales of financing with stock rather than with bonds? What are the disadvantages of using stock?
b. Is the stock of Gonzales Food Stores currently publicly held or privately owned? Would this situation change if the company undertook a stock sale?
c. What is classified stock? Would Gonzales find any advantage in designating the stock currently outstanding as founders’ shares? What type of common stock should Gonzales sell to the public to allow the family members to retain control of the business?
d. If some members of the Gonzales family wanted to sell some of their own shares to diversify at the same time that the company was selling new shares to raise expansion capital, would this choice be feasible?
Part II: Subsequent Expansions A few years after the initial expansion, Gonzales wants to build a plant and finance an operation that would manufacture and distribute its homemade salsa and related products to supermarkets throughout the United States and Mexico. Mr. Gonzales, CEO and family head, has begun planning this venture, even though construction is not expected to begin until the current expansion is complete and the company is financially stable, which might take several years. Even so, Mr. Gonzales has some ideas that he would like you to examine.
The project’s estimated cost is $30 million, which will be used to build a manufacturing facility and to set up the necessary distribution system. Gonzales tentatively plans to raise the $30 million by selling 10-year bonds, and its investment bankers have indicated that the firm can use either regular or zero coupon bonds. Regular coupon bonds would sell at par and would have annual payment coupons of 12 percent; zero coupon bonds would also be priced to yield 12 percent annually. Either bond would be callable after three years, on the anniversary date of the issue.
As part of your analysis, you have been asked to answer the following questions:
a. What is the difference between a bond and a term loan? What are the advantages of a term loan over a bond?
b. Suppose Gonzales issues bonds and uses the manufacturing facility (land and buildings) as collateral to secure the issue. What type of bond would this security be? Suppose that instead of using secured bonds, Gonzales decides to sell debentures. How would this choice affect the interest rate that Gonzales would have to pay on the $30 million of debt?
c. What is a bond indenture? What are some typical provisions that the bond-holders would require Gonzales to include in its indenture?
d. Gonzales’s bonds will be callable after three years. If the bonds were not callable, would the required interest rate be higher or lower than 12 percent?
What would be the effect on the rate if the bonds were callable immediately?
What are the advantages to Gonzales of making the bonds callable?
e. Consider the following:
(1) Suppose Gonzales’s indenture included a sinking fund provision that required the company to retire one-tenth of the bonds each year. Would this provision raise or lower the interest rate required on the bonds?
(2) How would the sinking fund operate?
(3) Why might Gonzales’s investors require it to use a sinking fund?
(4) For this particular issue, would it make sense to include a sinking fund?
f. At the time of the bond issue, Gonzales expects to be an A-rated firm. Suppose the firm’s bond rating was (1) lowered to BBB or (2) raised to AA. Who would make these changes, and what would they mean? How would these changes affect the interest rate required on Gonzales’ new long-term debt and the market value of Gonzales’ outstanding debt?
g. What are some factors that a firm such as Gonzales should consider when deciding whether to issue long-term debt, short-term debt, or equity? Why might long-term debt be the company’s best choice for this project?