George McGill Evaluation, Case Study Example

1990

In 1990, McGill decided to issue stock in Star Bay Company in an attempt to raise capital that was needed due to stagnant earnings despite increasing revenue. Assuming that there was a need for additional capital, the decision is then weighed against the alternative of taking on debt in the form of long term loans. The total needed was $20 million extra, which they could raise through commercial paper, non-convertible bonds, or common stock sales. Commercial paper is not a good idea as that is a method used for raising short term cash, and the indication is that this money was needed for more long term purposes. The decision can therefore be narrowed down to long term bonds or the issuing of common stock. It is likely that the wrong decision was made by McGill for the company’s sake. Star Bay Company was below the industrial average for debt, meaning taking on more was not something they had a special need to avoid. Considering their growth in revenue, coupled with expectations that their costs would fall or at least grow more slowly as they exited a period of heavy investment, it is likely that in the long term shareholders were paid more than bondholders, who were receiving a rather low interest rate. For these reasons, it likely would have been cheaper to issue bonds and would not have taken any decision making ability from McGill. With the principle of diminishing marginal returns in mind though, doing a little of both to raise the money likely was a smart idea for the company, however a higher percentage coming from bond sales would have been advisable.

1992

 Due to the decision to acquire a supplying company, the company again had to make a decision between issuing stock or bonds. They could either pay with twenty five million dollars of equity and avoid the need to raise any cash or they could purchase the company with cash they received from taking on debt. McGill recommended the cash purchase and the company picked a long term loan over a short term to get the cash. In this case, I believe the wrong decision was made. Outsiders had begun viewing the company as one that was constantly growing, while the internal view was that the company was not in as great of shape as many saw. Due to this, their stocks were likely overvalued, meaning that the twenty five million they would have given in stock would have had a true value below that actual total. They should have taken advantage of this overvaluing to issue equity to purchase this company. Also, long term debt is particularly bad idea as the company’s cash budget shows that is was in the process of picking up excess cash and could therefore pay off debt quickly, avoiding the higher interest rates that come with longer maturities.

1995

 This year, SBC was interested in retiring twenty five million of long term debt, with the plan of issuing commercial paper in the short term to pay that loan off. However, this move was delayed as McGill was given advice that the economy was about to undergo great deals of inflation, which would drive up interest rates. This is a case where the correct decision was made by McGill, assuming that the expectations of increased inflation were correct. The real interest rate paid by the company on the long term debt would be five percent minus the increasing inflation rate, while the short term commercial paper option would feature increasing nominal interest rates, and a basically static real interest rate. Therefore, the cost of borrowing would ultimately be higher with the short term option if there is inflation coming. However, McGill’s plan to simply delay this process is not advisable. Even if in several years the inflation rate seems less likely to increase, it is not always predictable, and the cost of the short term option could balloon quickly if inflation does start. Other not perfectly predictable variables, such as the company’s financial health or the credit available in the general economy, influence the cost of borrowing. Therefore, using constant streams of short term debt to retire long term debt is a very risky financial decision.

1999

 In 1999, the company was looking to grow and needed short term cash to fund that growth. Their options for raising this money were between short term debts at a seven and a half percent interest rate, long term non-convertible bonds at the same interest, convertible bonds at a six and a half percent rate with a forty dollar strike price, and selling common stock at thirty three dollars a share. The company ultimately decided to issue to the convertible bonds, raising the fifteen million dollars that they needed. This was the proper decision once again. The company was once again below the industry average for debt ratios, meaning they could afford to take on some. However, it should be noted that this maneuver will take them above the industry average.* The convertibles give them the lowest interest rate, which is extremely important in this case where the interest rates offered in other options are relatively large. Also, convertible bonds have this affect while not diluting their ownership level, unless there is great deals of growth in the share price, which is unlikely since the plan also calls for increasing their retained earnings level and they were already paying out dividends at about the industry average.  This means that McGill successfully implemented the correct policy to solve the cash shortage currently affecting the company. It would be easier to know this for sure if there was any information given about the threat SBC faced in losing control of its own operations from this action. This is an issue faced by any plan where the option of conversion is given for the company. This is a more serious threat depending on what percentage of  the shares they currently own.

*The current debt ratio is 35% on an asset total of 148 million. 148 million by .35 gives them a total debt level of 51.8 million previously. Issuing another fifteen million of debt will give them an extra fifteen million in cash, bringing the assets to 163 million and the debt to 66.8 million. 66.8 divided by 163 gives a debt ratio of 41%.

2002

As in 1995, the company had to make a decision on long or short term debt based on their expectations for inflation. In that previous year, McGill chose long term debt over short term debt based on his expectations for increasing inflation. In this situation, he once again had expectations of increasing inflation and again decided to try and shift the company’s debt from short term debt towards long term debt. Initially the debt was held in short term notes at interest rates of six percent, while the long term debt obviously comes with a higher interest rate, in this particular case a seven percent rate. This is designed to insulate against the effects of inflation, which can cause borrowing costs to increase greatly, while actually decreasing the real cost of debt already held. The quality of this decision is dependent on how reasonable the expectations for inflation are. If inflation is actually going to happen, the decision is advisable since this will lower the cost of borrowing. If inflation does not actually only occur, then maybe the costs of borrowing the money will be lower as the interest rate drops along with the inflation rate in the general economy.

2004

            In 2004, the company faced a decision regarding an investment in its physical capital that would allow it to increase their output to meet rising demand. The company faced an initially large investment, and decreasing incomes over a ten year period. The decision was made based on these factors. The project comes in with a negative net present value when the weight average cost of capital is used at the discount rate. This is the case even before interest payments are required. For this reason, the decision should have been to forego the project. Initially McGill had decided to undertake it and finance either through short or long term debt. However, he reconsidered as he had decided that there was sufficient cause for concern about the economy and that therefore they should not be expanding and in fact should be lowering their debt levels in anticipation. Ultimately, the correct decision was made by McGill for this situation.

2007

            A couple years after deciding not to expand the business operations due to fear for the general economy, McGill recommended undertaking the plan he rejected in 2004. The plan would require a floating rate bond to finance it. Even before interest payments are considered, the plan had an only slightly positive net present value, meaning with an increase in the payments made that would no longer be the case. Assuming that there was an interest rate of 8.75 the entire period, it would have become negative from an NPV standpoint. Therefore, the project should only be undertaken if this is expected to fall, which is a risky proposition. For this reason it was not advisable to take unless there was an increased expectation for revenue.

  1. 2. Up until the recent decision to accept a plan with a negative NPV, his decisions had certainly been improving with the company continuously making better financial movements on his advice. The first two times he had made the wrong decision when deciding between issuing equity or debt to finance investment. The first time this is shown by the large growth in share prices after they issued equity. However, after that the decisions have been significantly better as explained in the answers.
  2. 3. I would recommend that they keep McGill in his current positions as the majority of his decisions had been correct. However, he is not infallible and the company would be smart to allow more input from others and make their decisions less based on his own recommendations.