Lolonyo Foam Ltd (Lolonyo), an Accra-based unlisted company, has been manufacturing mattresses and other form products since 1990. The company is considering a new project which requires a GHS75 million investment in capital expenditure and net working capital. The directors of Lolonyo have decided to raise the needed funds through a new issue of 10-year subordinated bonds to investors in Ghana. Lolonyo uses a discount rate of 20% to appraise new projects. However, the directors feel that this rate will not be appropriate for this project as its financing method is different from what has been used in the past.
The following information is available for the company:
Earnings of the company for the past five years are as follows:
Directors intend to use the Kaplan Urwitz model for unlisted companies to assess the cost of debt. The Kaplan Urwitz model for unlisted companies is given by: 𝑌=4.41+0.001𝑆𝑖𝑧𝑒+6.40𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦−2.56𝐷𝑒𝑏𝑡−2.72𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒+0.006𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡−0.53𝐶𝑂𝑉
where :
Y is the credit score
Size is measured by total assets
Profitability is measured by the ratio of net income to total assets
Debt refers to the status of the debt stock; subordinated debt is assigned score 1, and unsubordinated debt is assigned score 0
Leverage is measured by the ratio of long-term debt to total assets
Interest refers to interest cover, which is measured by net operating income (i.e. net income before interest and tax)
COV is the coefficient of variation in earnings, which measures volatility in earnings
The table below presents credit score ranges and corresponding rating category and yield to maturity for 10-year corporate bonds:
Required:
Estimate the cost of debt. (8 marks)
View Solution
Calculate credit score (Y) using Kaplan Urwitz model for unlisted companies:
𝑌=4.41+0.001𝑆𝑖𝑧𝑒+6.40𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦−2.56𝐷𝑒𝑏𝑡−2.72𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒+0.006𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡−0.53𝐶𝑂𝑉
Where;
Size is measured by total assets
Profitability is measured by the ratio of net income to total assets
Debt refers to the status of the debt stock; subordinated debt is assigned score 1, and unsubordinated debt is assigned score 0
Leverage is measured by the ratio of long-term debt to total assets
Interest refers to interest cover, which is measured by net operating income (i.e. net income before interest and tax)
COV is the coefficient of variation in earnings, which measures volatility in earnings
Note: Since company has been operating since 1990, earnings record for the past five years is a sample of earnings. The standard deviation is therefore estimated as a sample standard deviation. 𝑌=4.41+0.001(150)+6.40(0.068)−2.56(1)−2.72(0.533)+0.006(12.333)−0.53(0.078)
𝑌=1.018
With a credit score of 1.018, Lolonyo falls into the BB credit rating.
The yield on 10-year corporate bonds with BB rating is 25.5%.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 𝑌𝑇𝑀×(1 – 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒)
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 = 25.5% × (1 – 0.25)
. = 19.125%