Growth financing is an important topic of consideration for managers since in order to continue the development of a business, one has to find the resources that will support this growth, which is a dilemma that EduSoft has faced. Evidently, to obtain money for the growth of a firm, the management has to secure financing, and the potential options include issuing debt or sharing the ownership of the company and its profits. There are several options that offer a combination of debt and warrants and allow businesses to obtain finances on more favorable terms as opposed to the standard stocks and bonds. This paper will analyze the growth financing case study and recommend alternative courses of action.
Analysis
The main issue in the case study is that EduSoft’s founder expects a shakeout of the education software industry in the nearest future, and unless EduSoft acquires a prominent market share, this company may fail to survive this upheaval. Due to the firm’s B rating and high-interest rates, the founder has three options to finance the growth: “preferred stock, bonds with warrants, or convertible bonds” (Brigham, 2019, 829). According to Samaniego‐Medina and di Pietro (2019), the Ba2/BB ratings shows that the company’s stock is below the investment grade because the default risk of these businesses is higher when compared to firms that receive the A grade ratings. Evidently, EduSoft will not be able to obtain finances through the standard methods of investment due to its low ratings, which is why this case study analysis will focus on the discussion of the alternatives.
Reverting to hybrid models allows business owners to take advantage of the positive attributes offered by bonds and stocks. By definition, hybrid financing, which is the option that EduSoft’s CEO has selected, is the combination of the properties of equity and bond (Brigham, 2019). With this in mind, there are also risks associated with the hybrid approaches as well as return characteristics; for instance, some provide holders with tax benefits or allow the investors to receive their face value.
Based on the current assessment, it is recommended that EduSoft’s management uses the warrants model because it will benefit both the company and the holders of the warrants. When compared to the option that closely resembles bonds with warrants, which is convertible bonds, the former is more attractive to the investors considering the changes that will occur in the market and the high chance of failure that EduSoft faces. Notably, Baldridge and Curry (2021) argue that convertibles offer all the benefits of stocks and bonds, meaning that the company is paying the investors the coupon rate until one of the two parties decides to trigger the conversion.
Solution
The best solution in the case of EduSoft is to issue bonds with warrants that will provide the company with the needed funding and ensure that the investors feel secure when purchasing this instrument. Brigham (2019) recommends this option for high-tech firms because it is a secure solution both for the investors and the owners of these companies. EduSoft’s financial manager should consider the perspective of the investors and the factors they will take into account when choosing between EduSoft’s and other companies’ offers. When discussing warrants, Abreau (2019) reports that “when investors are driven to trade in financial markets for pleasure/fun, they tend to trade complex products more and to trade simple and easier to understand financial instruments less” (p. 139). Considering the market conditions, choosing warrants as a solution would be a better guarantee for EduSoft that the company will secure funding since this instrument is relatively simple, and the investors may prefer it over other options due to this simplicity and the market changes that are about to occur within the education software industry.
Based on the financial manager’s decision, the value of the bond should be set at $850 while the payment must be $100. The coupon rate for the bonds if the total package is sold at a par of $1000 should be 10%. The warrants should be exercised until their expiration date. If the warrants were issued at the price of $5, the total price of the package should be $1090, and the firm could sell have a smaller present value by $90 of the package. In case the warrants are sold after 10 years, the price should be $$43.18, and the cost of 45 warrants would be $818.10. For question d, the conversion price of the bond is $25, while the convertible’s straight value is $872.30. The formula for the bond’s expected conversion is CVt= CR(Pt) = CR(P0)(1 + g)t= 40($20)(1.08)t. Hence, the cost after 10 years is set at $1,727.14. At year 0 the floor value is $872.30 as opposed to $1,727 at year 10.
Justification
First, it is necessary to review the definitions and specifics of the preferred stock, warrants, and convertible bonds to justify the selection of warrants over other options. According to Brigham (2019), preferred stock is a hybrid between debt and security that allows a firm to avoid the risk of bankruptcy since there is no need to pay preferred dividends. Moreover, when compared to debt, the preferred stock has a higher cost of capital. The dividend on this type of stock is set when they are issued and cannot be changed in the future, but the market price of the stock itself can change based on the conditions of the market (Brigham, 2019). Generally, this type of stock does not have a maturity date, but Brigham (2019) notes that in recent years this characteristic has been included by some issuers. Finally, the owners of this type of financial instrument have no voting rights, which means that they cannot affect the decisions made by the organization.
The downsides of preferred stock include the issuers’ right to omit to pay the dividends when facing temporary problems, which would be beneficial for EduSoft since the organization could face many challenges when competing for the market share in this field, allowing this business to avoid bankruptcy due to nonpayment. However, unlike with bonds, choosing to omit the payment of dividends on preferred stock will cause the other potential investors to reconsider and avoid investing in this business. This creates a risk for EduSoft since, considering this strategic direction, it will require additional financing. Hence, the CEO of EduSoft should avoid choosing the preferred stock as the hybrid financing model because it will limit the potential growth of the business, which is required considering the market conditions.
Warrants are the insurance of another type of security issued as derivative securities (Brigham, 2019). With a warrant, any person who has purchased this instrument has a guarantee that they will be able to buy stock for a specific price within a set period of time. Brigham (2019) notes that warrants are typically issued alongside debt. The main benefit of this option is that if the company’s stock price increases, the investors will have the right to buy its stock at a price specified in the warrant. Hence, the instrument is a guarantee that when EduSoft secures a substantial market share, and its stock price will increase accordingly, the individuals who have purchased the warrants will be able to receive their equity in the firm at the stock price that the company currently has, which is a promise of a substantial profit. This option is also less burdensome for EduSoft when compared to the other two and will allow the managers to focus on growth rather than on paying off the dividends. Moreover, Brigham (2019) notes that warrants are typically used by small firms that sell stock as a way of attracting investors because these companies are viewed by the investors as risky, and therefore, they have a limited chance of obtaining funding.
Convertible bonds are instruments that combine the features of warrants and debt (Brigham, 2019). The main benefit of this instrument is that it allows the investor to convert the bonds into common stock under a fixed rate. Evidently, this instrument may be attractive for the potential investors since it will allow them to own equity of EduSoft if the CEO’s plan towards securing a substantial market share is successful. However, the downside of this instrument is that in case of failure, unlike when purchasing warrants, the investors will lose their money. It is an important point of consideration since the education software market, as was mentioned in the case study, is on the verge of a transformation, meaning that it is a high-risk industry, which is further affected by EduSoft’s B rating.
When comparing the convertible bonds with warrants, the latter is less attractive for the investors because, as Brigham (2019) notes, it allows the firm to sell the company’s common stock at a higher price when compared to the one that is currently in the market. Moreover, Went (n.d.) states that “by reconciling differences in risk aversion and diminishing managers’ exploitation of investors,” convertible bonds help reduce agency costs (p. 1). However, considering the close alignment of the elements that are consistent with the convertible and warrant option, the financial manager should look at the risks that the investors will consider when making their decision.
Summary
In summary, this paper is the analysis of the case study on growth financing. EduSoft is competing in the market of software for the education businesses, and the current rating of the enterprise is B. The CEO has three options from the hybrid financing domain to obtain the funds needed to ensure that this company grows and secures a market share sufficient for overcoming the upheaval. The recommended course of action is choosing warrants with bonds because this is the most secure method both for the investors and for EduSoft. The business will have the finances without the need to give up equity right away, while the investors will have a guarantee that a portion of their funds will be retrieved even if EduSoft is unsuccessful.
References
Abreu, M. (2019). How biased is the behavior of the individual investor in warrants? Research in International Business and Finance, 47, 139-149. doi: 10.1016/j.ribaf.2018.07.006
Baldridge, R. & Currey, B. (2021). Convertible bonds give you the best of both stocks and bonds.
Brigham, E. (2019). Financial management: Theory and practice. Cengage.
Dent, J. (n.d.). The role of covertible securities in corporate finance. Web.
Samaniego‐Medina, R., & di Pietro, F. (2019). Rating and capital structure: How do the signs affect the speed of adjustment? Journal of International Financial Management & Accounting, 10-20. doi:10.1111/jifm.12106