Sent: 08-09-2009 10:09:01
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Ignoring the Cost of Equity
Many companies remain disappointingly oblivious to the impact on their financial performance of equity issuance.
Junior miner Platinum Australia announced recently that it had agreed to issue options over 7 million shares in part payment to its banker for a financing facility but failed to disclose the cost of the payment or the impact on its shareholders.
Proper corporate decision-making usually requires some assessment of the impact of a decision on financial rates of return. A decision to make an investment should follow an assessment of how much capital is needed and how much income will flow. In simple terms, if the resulting return exceeds the cost of the capital required, it should be a sensible investment that adds value for the owners of the business.
The cost of debt financing is normally straightforward. However, equity financing costs are less straightforward because equity does not necessarily incur ongoing charges with a direct cash impact. That leaves executives vulnerable to entreaties from brokers delivering apparently low cost financing.
Without any improvement in the underlying operating performance of a business, an opportunistic equity capital raising of the sort that has been so prevalent recently simply reduces the rate of return of the overall business and diminishes the value of the business for pre-existing shareholders.
In requiring the value of employee share options, for example, to be expensed, accounting authorities ensured that companies more fully recognized that equity comes at a cost. This was an important message for those companies which had been acting as though equity issuance did not reflect adversely on their financial performance.
The new accounting standard forced companies to recognize that share based employee rewards came at a cost and would have to be justified by offsetting benefits to the company from the employees receiving them.
In the interests of clear disclosure, the same logic should apply to any share based transaction.
Platinum Australia recently announced that it had negotiated a $15 million bridging loan from one of Australia's major banks. The terms of the loan involved an 8% per annum rate of interest and a 1.75% facility fee both of which will show up in the company's expense statement and which, at face value, seem reasonable enough.
However, the company also agreed to issue a series of options with an August 2011 expiring to the lending bank. Under the terms of the agreement, the company must issue options over 1.428 million shares starting immediately and at the end of each quarter until September 2010 and while the facility remains in use.
The company made no attempt to declare the value of this part of the package. On my reckoning, a two year option in this stock issued on 21 August at a strike price of $1.05 should be worth approximately 41cents.
If the facility does remain in place until August 2011, the company would be obliged to make payments of:
- $262,500 for the facility fee;
- $2.4 million for the interest payment; and,
$2.9 million through the value of the options issued to the bank.
If the cost of the options is included (in the same way as it would be if they had been issued to an employee or contractor for personal services), there would be a total expense of $5.6 million over two years or an effective annual interest rate of approximately 18.7%. This is radically different from the rather innocuous 8% which was quoted by the company as its cost of financing. It might be cheaper to use a credit card.
In failing to quantify the full cost of its financing transaction, the company has left the distinct impression that it did not have a full understanding of how much it was paying or the full extent of the added burden it was placing on its shareholders.
This is not to say that the transaction was unjustified. Despite everything, this might still be a cheaper source of financing than any available alternative and lower than the rate of return generated by the projects into which the funds are being invested. But the operative word here is "might". The company failed to make this case and, as investors, we are simply forced to hope that they have got it right.
John Robertson is a member of the investment committee of the Emerging Resources Company Share Fund, a specialist resources sector equity fund (http://www.eimcapital.com.au/ercsf.htm) which owns shares in Platinum Australia.
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