The case study depicts a scenario in which it is obvious that expansion is a necessity in order to increase return. As mentioned in the case, a new park attracts a lot of local attention and also gets a significant amount of press coverage which creates a great deal of excitement in the community. Hence, for the first few years the new parks reach peak revenue which makes them profitable. Also, the investment is quickly recovered. Nevertheless, as this novelty wears off the revenue growth declines. Furthermore, HiJinx had committed to opening around a dozen new stores and had already built up substantial infrastructure to facilitate its projected growth. It could not default on its obligations. Therefore, HiJinx Inc has no choice but to expand in order to maintain the revenue growth.
For this reason, HiJinx Inc. has to find the best way to raise approximately $ 30 million for expansion. Before deciding which project to undertake, it is important to recall and list the options available to Kenna Christy, the CEO of HiJinx Inc. These options are discussed below.
- The first option available to the company is to issue initial public offerings (IPOs) of 2 million shares at lower price than that mentioned in the prospectus. The initial price of $14 to $16 per share is claimed to be too high by the banker and thus Christy will have to lower this rate in order to sell the IPOs.
- The second option is for the company to utilize the newly arranged $7.5 million credit facility that Royal Bank of California had recently opened for HiJinx.
- Another option for the firm is to only take lease in mall C firms where the landlord contribution can help in the initial investment and this could be paid back over the period of ten years out of the stores revenue.
- The fourth option is the HiJinx’s financial backers to invest another $10 million in the company should the proposed IPO be delayed. They offer 2,500,000 shares of $4 each earning a return of 8% per year.
Keeping all these options in front shows that no one option can be relied upon to finance the expansion completely. Therefore Christy has to derive a strategy to raise capital in order to fund the 10 years expansion plan.
For now the feasible option for her is to allow the private equity investors to invest in the company, invest in mall C where landlord contributions decrease the initial investment in each store and also avail the credit facility provided by Royal bank. Issuing IPOs in 1998 will be extremely risky because market conditions are ambiguous and, therefore, for now, the IPOs should be delayed.
And should the company maximize the net present value of its invested dollars, or the internal rate of return (IRR) on its projects?
The company should maximize the NPV rather than the IRR. In the decision making process, IRR is mostly used as an additional information to the NPV. Where NPV determines the absolute return on an investment while the IRR just gives a rate of return percentage. Therefore, if the company's objective is to maximize shareholders wealth, it must try to maximize its net present value (NPV). The most important problem with IRR is that, in a few cases, managers may reduce Shareholders wealth by rejecting Projects with higher (positive) NPV, when they focus solely on maximizing IRR.
In case of HiJinx Inc., we see conflicting decisions resulting from analyzing NPV and IRR. When compare the NPV and IRRs of HiJinx Stores in “A” Malls, with no Landlord Contribution and HiJinx Stores in “C” Malls, with Landlord Contribution in "NPV and IRR in A C mall" worksheet, we see that the IRR of mall C is higher than that of mall A. Thus, the company invested in Mall C, however, the actual absolute return is the NPV of the malls which needs to be compared when deriving strategies to maximize the shareholders' wealth. For this reason, Mall A is a better investment than Mall C because Mall A has higher NPV.
When should leverage be used to enhance returns?
Leverage is debt in relation to equity in a firm's capital structure that is calculated by the debt-to-equity ratio
. Financial leverage increases as we take on more long-term debts. Shareholders benefit from increased leverage only to the extent that returns on the debt invested is higher than the interest costs.
Leverage should only be used to finance a project when a firm is fairly sure that it will earn a consistent return and is also a risk taker. Even though, it assists both the investor and the borrowing firm to invest or operate, high leverage has a great deal of risk associated with it. In business, a firm could use the borrowed funds to try and generate shareholder wealth, however, if it fails to do this, the interest expense and credit risk of default eats away the shareholder value like a parasite. Therefore, the most desirable amount of leverage largely depends on the stability of HiJinx Inc's earnings.
With reference to the case study, it is apparent that Christy is fairly certain that an expansion will bring about high returns in the next ten years before the market saturates, thus it will be willing to take on debt if need be. The forecasted income statement also shows an increase in profitability over the ten year expansion period.
Additionally, as long-term debt interest is a fixed cost, HiJinx should forecast if it would have enough cash available to pay the interest (as well as other expenses) on timely basis, otherwise the firm can face a risk of bankruptcy. In the case study, we have already seen that Discovery Zone and Showbiz had gone bankrupt when they were not able to pay off their creditors.
Finally, it is important to identify the role of long term debt as a signaling move. If HiJinx borrows money to invest in expansion this signals to the market that higher returns are to be expected in the future. This will eventually lead to a higher demand and, hence, a higher market value of the common stock and any initial public offerings issued thereafter could be sold for a higher price than $16.
The proper financial policy for the company?
As discussed in the first question, HiJinx cannot finance the expansion with just one option unless it issues an IPO at lower price. A far better proposition would be to delay the issuance of these IPO. First of all, the company should agree to private equity investors who are optimistic about the progress of the company and are only concerned about the profitability of the firm.
Additionally, for the first few years in which funds are low (due to the delay of IPOs), the firm should chose mall C location so as to use the landlords contribution to reduce the initial investment on each store. However, once the IPOs are issued, the investment could be done in higher NPV projects in mall A. This way HiJinx will be able to maximize its revenue and profits keeping its budget constraint in mind.
The company should also take on a little long term debt to signal to market the investment in expansion and higher future returns. In the corporate environment, signaling is also a determinant while deciding the debt equity mix. Mostly a move of borrowing funds for longer term depicts to the market that the firm is expanding and a higher return could be expected in the future. Hence, the demand for the stock increases and this causes the market value of the HiJinx stock to increase. Thus, as a tool for signaling taking on debt could be a important move.
Furthermore, the increase in revenue and profits over the first few years will also lead to higher earnings per share which will hopefully increase the market value of the stock. When the market values of the stocks increases, it is then the time for the firm to issue the IPOs. The IPOs can be sold for a premium or a higher price could be charged in the prospectus. This move will help HiJinx raise all the required finance to fund the expansions as well as pay off any short term or long term liabilities (especially that of royal bank).
The strategy for raising money for expansion has already been discussed in some detail and we now see what other steps HiJinx could take. Firstly, HiJinx should research as to why when the novelty wears out people stop going to a park. Rather than making new parks, the priorities should be to improve the existing parks. The company should do market research to understand the wants of the people with reference to these parks and then analyzing and applying the result to these parks in order to improve their revenue. If this is not done then the firm will only be in existence for a few years before it completely backs out when market becomes saturated. There is no long term perspective of the firm beyond 10 years. Therefore, an investment in reinventing the existing parks, advertising and market research is crucial for the firm.
Additionally, investment should also be done on research so as to develop a strategy to get a competitive edge over others. This is crucial because HiJinx is operating in a very competitive atmosphere. Furthermore, as the company takes debt over the first few years, it has a sword of bankruptcy hanging over its head. To avoid this, revenues and profits have to be boosted and new customers have to be attracted to the stores.
As far as Christy is concerned, the above given financial strategy would ensure an increase in her wealth as well as that of the shareholders. When the Market value goes up due to the signaling by debt and improved profitability, Christy can utilize her call option and by selling to the public at higher price could increase her wealth. Thus, in this strategy there is an incentive for Christy. Also note that the shareholders wealth also increases in this financial strategy.
Through this strategy, especially given the option of utilizing the credit limit, the company will also be able to pay off the debt obligations and leases well on time. So, bankruptcy for most part can be avoided. Furthermore, this gives a boost to revenue and profits ultimately increasing the market value of the firm's stock. This fulfills the objective to maximize shareholders wealth as well.