Company Analysis: Arrow Electronics Limited
Answer 1)
The cost of long-term bond issued by the company has been calculated on the weighted average basis. The calculations follow hereunder:
It is considerable that every organization has an appetite for capital. However, while there are many sources to raise capital, it is extremely important to weigh the pros and cons relating with each such source.Below we have discussed some of the likely benefits and limitations of issuing bonds, in relation to Arrow Electronics:
-Advantages of issuing bonds:
i) Tax deductibility:
One of the biggest advantage offered by bonds is the tax deductibility associated with it. It is considerable that both US GAAP and IFRS accounting standards allow the companies to expense the interest payments made to the bond holders. This results in lower net profits and lower tax bills for the company. On the other hand, no such provision is allowed for any payments related to the equity issue. Therefore, issuing bonds offers tax benefits for the company.
ii) Low cost of capital
At times when a company raises equity capital, the value of existing shares is diluted and the existing shareholder demands a higher rate of interest in exchange of the higher risk associated with the additional equity issue. On the other hand, since debt issues are either supported by collateral assets or liquidity preference for the bondholders, they tend to be a cheap source of capital. Henceforth,in comparison to equity issues, bond issue offers capital and lower rate of interest.
iii) No dilution of ownership
Unlike equity issues, which results in dilution of ownership and a consequent interference in managerial decisions, bond issues does not result in any sort of dilution or authority to interfere in the managerial decisions of the company. Here, the company issuing bonds is only liable to make timely interest and principal payments to the bondholders and is required to follow other provisions of the bond covenants.
iv) No dilution of share of profits
Since the issue of bonds does not result in additional dilution of shares, earnings per share tend to remain higher and each share retains its earnings per share ratio.
Company specific advantage
v) Benefits of Financial Leverage
Assuming that a company is able to efficiently deploy the borrowed funds and is able to earn an internal return greater than the cost of capital, then involving debt in the capital structure results in increased wealth for the shareholders. For instance, above, we found that the weighted average cost of the company’s debt is 5.024%. Henceforth, if Arrow Limited is able to earn 9% by investing these funds, then the remainder, 3.976% is shared by the equity shareholders as interest cost on bonds is fixed and returns over and above that particular costs spill over into the hands of shareholders and results into wealth maximization.
-Disadvantages of issuing bonds:
i) Associated risk of bankruptcy
Unlike equity issue where the company is under no obligation to return the money, bonds issues make it obligatory for the company to make timely interest payments and follow all the terms of the bond covenant. Thus, in the event of non-payment of debt payments, the company can face bankruptcy issues as part of which bondholders will have full entitlement over the company’s assets.
ii) Tarnished Corporate Image
Even irregular payments to the bondholders can spread negative sentiments about the company and this can impose a serious threat to the corporate image of the company.Consequently,other stakeholders such as suppliers and customers might not be interested to show continued faith in the company.
iii) Effect on Bond Rating
At the time of bond issues, rating agencies like S&P 500 and Moody’s give ratings to the issue on the basis of credibilty of the issuer and other factors related to the issue. Therefore, even if the company fails to make timely payments or defaults on any one bond issue, this will place a blot on its credit rating and will undermine its capacity to borrow funds at lower rate of interest in the future.
iii) Enlarge Leverage Ratios
Analysts and investors dislike companies with high leverage ratio and one of the negative effects of the bond issue is that it inflates the leverage ratios signaling towards increased risk embedded in the company. Investors may also perceive the risk of increased project costs on financial ratios after the bonds are issued. For instance, if due to unforeseen market conditions, the cost of the project increase unexpectedly and the company fails to generate a sustainable operating income from the project and since interest expense is fixed, this will result in a decreased interest coverage ratio. Henceforth, any such negative outcome indicates that the company is losing its ability to honor debt payments.
iv) Restrictive Covenants
At the time of the bond issue, both bond issuers and investor enter into an agreement of restrictive clauses known as ‘Bond Covenant’. The covenant contains many restrictive clauses related to usage of assets, creation of liabilities,cash flows and control, et cetera. which restricts the management from using borrowed funds with liberty thus affecting the effectiveness of the decision making process.
Answer 2&3)
Tax rate and after-tax cost of debt
i)Tax Rate: Provision for tax/ Earnings before tax
= 184943/683333
= 27.06%
ii) After tax cost of debt: Weighted average cost of debt*(1-tax rate)
= 0.0524*(1-0.2706)
= 3.822%
Answer 4)
Referring to the above table, we can witness that, except for two bond issues, Arrow Electronics 3.5% and Arrow Electronics 4%, all the other bonds are trading at the premium price. It is considerable that a bond will trade at a premium price if the coupon rate is greater than the yield to maturity, vice-versa for bond trading at a discount. Important to note, while the coupon rate of bonds remains fixed until the maturity, it is the change in YTM that determines whether the bond will trade at a premium or at a discount.
Accordingly, factors that affect YT M of bonds should evaluated here and one such factor is the rating issued for the company’s bonds. It is considerable that the bond issues of the company are rated by three major credit rating agencies - Moody's Investor Service, Standard & Poor's, and Fitch Ratings and since each of these rating agencies have issued a stable outlook for the bond issues of the company, the majority the bonds are trading at a sustainable premium levels.
References
Arrow Electronics. "Annual Report 2014." Annual Report . 2014.
Bonds: Arrow Electronics. n.d. 1 February 2016 <http://quicktake.morningstar.com/StockNet/bonds.aspx?Symbol=ARW&Country=USA>.
Investor Relations: Arrow Electronics. 2016. 1 February 2016 <http://investor.arrow.com/phoenix.zhtml?c=85834&p=irol-faq>.
Motley Fool. Advantages and Disadvantages to Issuing Bonds in Order to Raise Capital. 10 January 2016. 1 February 2016 <http://www.fool.com/knowledge-center/2016/01/10/advantages-and-disadvantages-to-issuing-bonds-in-o.aspx>.
