QUESTION 1 (12 marks; 22 minutes)

Sonskyn Limited is listed on the JSE-Securities Exchange’s ALTX board. The company plans
to expand its business interests in the rest of Africa and needs R145 000 000 of financing in
order to continue with this expansion.

According to management’s expansion strategy the business must initially establish itself
and penetrate the market of the other countries. As a result it is expected that the expansion
project will only start rendering large returns over the long term. Meanwhile it does lower the
company’s risk exposure as it ensures that the company is more diversified.

Management is considering the use of one of the following two financing instruments to
acquire financing:

1. Issue of convertible debentures at face value – Listing on JSE Debt Market

These debentures will be issued with a face value of R200 each and a coupon rate of 11,5%
per annum, payable annually in arrears. The debentures will be converted to ordinary shares
of Sonskyn Limited after eight years. The conversion value of a debenture is its face value
and it will be converted in relation to the trading price of ordinary shares at that stage (face
value to trading value conversion). The yield to maturity of similar debentures that are
currently trading in the market, amount to 11% per annum.

The trading price of ordinary shares of Sonskyn Limited is expected to amount to R500 in
eight years’ time. Sonskyn Limited currently have 1 100 000 ordinary shares in issue, each
carrying one voting right.

2. Issue of redeemable cumulative preference shares – Listing on ALTx

These preference shares will be issued carrying a nominal value of R250 each and will bear
cumulative interest at 7,5% per annum, payable annually in arrears. These shares will be
redeemable at its issue price at any time after six years from now, but must be redeemed at
the latest 8 years from now. Currently the required return on similar shares in the market is
8% per annum.

The general consensus is that the required rate of return on similar shares should decrease
to 7% per annum in 6 years’ time and then immediately after that start increasing to a level
above 12%. It is expected that the required rate will stay at this high level for some time.

Currently Sonskyn Limited has no issued preference shares.

You can assume that the income taxation rate in respect of companies amounts to 28% per
annum.

REQUIRED
Calculate and discuss which factors the management of Sonskyn Limited should consider
when they evaluate which one of the two abovementioned instruments they should use as
financing instrument.
(12 marks)
QUESTION 1 – SUGGESTED SOLUTION (20 marks)

a) Factors the management of Sonskyn Limited must take into consideration during the
evaluation of the two sources of financing (financing instruments), includes:

Return
- Management should consider the after-tax cost of debentures of 7.92 %( 11% x (1 -
0.28) is which is lower than the 8% cost of preference shares, therefore the
debentures are slightly cheaper. (1)
- The cost of issuing shares on the JSE-Securities Exchange, even on the ALT X as
well as the cost of issuing debentures on the JSE Debt Market can be high.
Management should consider which alternative would be relatively more cost
effective based on the company’s needs. (1)

Risk
- Interest payments on the debentures are compulsory annual payments, while
cumulative dividend can be postponed if the company does not have the funds to pay
it. (1)
- Management should also consider whether enough funds will be available to redeem
the preference shares when they become redeemable in 6 to 8 years’ time, as the
project will only start rendering large returns on the long term (i.e. longer than 10
years). (1)
- The difference in financing period must be taken into consideration, since dividends
on the preference shares will only be paid up until the redemption date, while the
debentures will pay interest up until the conversion date and dividends indefinitely
thereafter. (1)
- The debentures on the other hand, don’t have to be paid back in cash and becomes
part of the permanent capital of the company (1).
- The company will also consider whether it will take on additional debt after assessing
the current capital structure. (1) [No additional information has been provided
regarding the target capital structure, the current debt ratio or any other measures.]

Control

- If and when the debentures are converted into ordinary shares, a dilution in the
control of existing shareholders will occur. (1)
- Thus dilution is very relevant as the new shareholders will hold more than 20% (calc
1 and 2) of the new voting rights, which will give the new shareholders a degree of
control over the company. (1)

Other
- Since the company is listed on the ALT X-board, the issuing of shares must comply
with the requirements of the ALT X. (it is assumed that the company already complies
with the general requirements, as it already listed there with regard to its ordinary
shares).(1) If the debentures are issued, the company must comply with the
requirements set by JSE Debt Market with reference to the issuing and listing of
debentures. (1)
- Other valid, applicable and sufficiently discussed points (1)
If a student advised management to try and make use of a source of finance in the
same currency as the currency in which the investments will be made and thus in
which the returns will be generated (rest of Africa) to limit exchange rate risk (forex
risk), a bonus mark can possibly be awarded for this.(1)
Calculations:
1. Number of debentures that needs to be issued (as no information has been provided,
it is assumed that the debentures are issued at their face value)
R145 000 000/R200 = 725 000
2. Number and percentage of new shares that would have to be issued as a result of
the conversion of the debentures

Conversion occurs at 1 share for each 2,5 (500/200) (1) debentures held.
= 725 000/2,5 = 290 000(1) ordinary shares would have to be issued at conversion.

Currently 1 100 000 ordinary shares are in issue and this will become 1 390 000
shares on conversion.
I.e. the percentage voting right held by former debenture holders should amount to =
290 000/1 390 000 = 20,86% (1) – thus material enough to afford a degree of control.

(Maximum 12 marks)