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Juma Company Ltd. Which is effectively controlled by the Juma family although they own only a minority of shares, is to undertake a substantial new...

Juma Company Ltd. Which is effectively controlled by the Juma family although they own only a minority of shares, is to undertake a substantial new project which requires external finance of about Sh.400 million, leading to a 40% increase in gross assets. The project is to develop and market a new product and is fairly risky. About 70% of the funds required will be spent on land and buildings. The resale value of the land and buildings is expected to remain equal to or greater than, the initial purchase price. Expenditure during the development period of the first 4 to 7 years will be financed from other revenue of Juma Company Ltd. This
will have a consequent strain on the company's overall liquidity.
If, after the development stage, the project proves unsuccessful, then the project will be terminated and its assets sold. If, as is likely, the development is successful, the project's assets will be utilized in production and the company's profits will rise considerably. However, if the project proves to be very successful, then additional finance may be required to further expand the production facilities.
At present, Juma Company Ltd. Is all equity financed.
The financial manager is uncertain whether he should seek funds from a financial institution in the form of an equity interest, a loan (long or short term) r convertible debentures.
Required:
(a) Describe the major factors to be considered by Juma Company Ltd. In deciding on the method of
financing the proposed expansion project.
(b) Briefly discuss the suitability of equity, loans and convertible debentures for the purpose of
financing the project from the point of view of:
(i) Juma Company Ltd.
(ii) The provider of finance.
Clearly state and justify the type of finance recommended for Juma Company Ltd.

Answers

Kavungya
(a) The following are among the major factors to be considered by Juma in deciding on the method of financing the proposed expansion project.
(i) Liquidity during the development period
Ideally the finance selected should minimize the drain on cash flows during the development period.
(ii) Terms of finance
Finance is required for at least 4 – 7 years hence short term loans which will require refinancing
are not suitable. However, long term or permanent finance may produce an excess
of funds after the development period if the project proves to be unsuccessful.
(iii) Risk
Debt with contractual interest and repayment, patterns may prove risky for Juma's
cash management activities. Equity, without any contractual dividend requirements, may prove
to be the finance source with lowest risk for Juma's management.
(iv) Debt capacity
There may be goods for issuing debt, thereby utilizing some unused debt capacity and
taking advantage of the tax deductibility of debt interest.
(v) Possibility of further finance required
It is possible that further finance will be required after the development period. Hence
financing decisions should be taken in a dynamic context whereby consideration is given
to possible further finance requirements.
(vi) Dilution
An increase in equity by issuing shares to new shareholders will reduce the control and
possibly, depending upon the issue price and quantity of shares issued, the wealth of
existing shareholders.
(vii) Use of funds raised
Funds should be raised only if their use appears to be productive.

(b) From Juma's viewpoint
(i) Equity
Extremely suitable from the liquidity aspects as dividends need not be paid.
If the project is not successful then permanent funds will result. However, if the project is
extremely successful the greater equity base will provide even further debt capacity to
facilitate further expansion. Would dilute the holdings of current shareholders.
(ii) Loans
Would utilize some unused debt capacity. Interest payments would be required under all
circumstance but would be tax deductible. Term of the loan may be difficult to arrange in
order to provide the medium term (up to 4 – 7 years) or long term finance.
(iii) Convertible debentures
Have the advantage that investment payments are tax deductible but are usually lower than the
interest rate on ordinary loans thereby conserving them the debt will be converted into equity and
could then provide the equity base for further debt financing expansion.
If the project is not successful then conversion will not take place and the debenture can be repaid.
Conversion into equity will usually result in fewer new shares being issued with consequent less
dilution.
From the finance provider's viewpoint
(i) Equity
Enables participation in the success of the firm but provides no security in the event of the
project not providing successful.
(ii) Loans
Provide security and regular interest payments but will not permit participation in
any success of the firm.
(iii) Convertible debentures
Provide the security of a loan with the possibility of favourable (but not unfavourable)
equity participation. However, in order to obtain this protected position the interest received
is usually lower than a normal loan and the conversion terms result in fewer shares than
would be obtained by an initial investment in equity.
In the circumstances of Juma, the use of convertible debentures is recommended as they will
utilize debt capacity and provide medium term or long term finance as required by the
outcome of the project.
The debentures should be convertible into equity from about year 4 onwards at the
holder's option unless previously repaid by Juma. Juma should arrange a repayment option
during the period of about years 4 – 7. The debentures could be secured on the land and
buildings to be purchased.
Kavungya answered the question on April 17, 2021 at 21:17

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