Professional Documents
Culture Documents
Submitted to:
Prof. Kulbir Singh
Section B2CD1
Submitted by
Introduction
Wells Fargo & Co. The central question in this case is whether Wells Fargo should issue
Convertible debt or not. If not Wells Fargo, ideally or theoretically speaking who should issue
convertible debt? The discussion can revolve around the qualitative aspects of the convertible
debt. The case also highlights the opportunistic financing and Atkins philosophy of raising
capital.
We will be analysing the case from two points of view. From the companys point of view as
well as the investors point of view.
Whether Wells Fargo and Co. should go ahead with the bonds issue or not?
1.1 History repeats itself
The table below shows the historical price, PE and EPS over the past 3 years.
Date
Price$
EPS$
P/E
11.9449
31-12-2000
28.19
2.36
2
11.0050
31-12-2001
21.9
1.99
3
7.42006
31-12-2002
01-04-2003
23.67
23.2
3.19
2.11
3
11
Although in the case it is mentioned that the price of Wells Fargo & Co. on 25th April 2003
was 47.45, we have found out that the actual price of the company was When one looks at the
historical earnings of Wells Fargo & Co. we can see that over the past two years it has grown
at a CAGR of 16.38%.
For Wells Fargo & Co. to reach $120 in 5 years the company would have to grow at a rate of
20.38%, if we assume that the current share price is fairly valued. Therefore, according to us,
to have a sustainable growth rate of 20.38% is very difficult and hence the share price
reaching $120 within 5 years is a rare occasion.
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1.2 Tax Benefits for Wells Fargo if the bonds are issued
In the case it is mentioned that according to IRS rules, Wells Fargo would be eligible for
deduction from income an interest amount which would be the prevailing market rates i.e.
5.8%. Therefore, the income tax saved here would be the tax rate on the difference between
the market interest rates and bonds interest rates, i.e. 4.75% (5.8% - 1.05%).
So, the table below shows the interest amount saved per year and the tax amount saved per
year and the total of both for the next 5 years.
Figures in millions $
Principal
Interest
Year
1
2
3
4
5
amt.
3000
3000
3000
3000
3000
Total
Amt
135
135
135
135
135
675
Tax
amt
saved
50.193
50.193
50.193
50.193
50.193
250.965
Over and above this amount, an additional amount could be earned on these tax savings if it
is invested in the safest treasury security bonds.
1.3. Accounting benefits for Wells Fargo if the bonds are issued
According to US GAAP, the shares would be convertible only if it reached a share price of
$120. Also, when it is converted the total number of shares converted shown in the balance
sheet would not be 1:10, rather it would be the additional price over 100 multiplied by 10
divided by the current market price. For example, in this case if the price reached 120, then
the total number of additional shares shown in the balance sheet would be:
(120*10 1000)/120 = (1200 100)/120
= 200/120
= 1.67
However, these will only be a book entry but sometimes it is enough to woo shareholders,
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because very few investors look at the notes to accounts and only see the financial statements
on its face value. Hence, many a times this kind of accounting policy is enough to attract
investors.
2. Whether Investors should subscribe to these Bonds issue or not?
Now, looking from the investors point of view, some of the strong reasons for not investing
in these bonds are as follows:
1. The basic assumption that the investor is making here that the stock price is going to
touch $120 in the next 5 years, which means that the company will have to grow at a
CAGR of 20.38%. This scenario looks a lot difficult considering the past two years
CAGR of around 16%.
2. If the investor is of the strong opinion that the stock will reach $120 in the next 5 years,
then there is no point in subscribing for this issue which will be converted at a price of
$77.01. He might as well purchase the shares at todays market price of $47.45 which is
$29.56 cheaper than the conversion price.
It is true, that the investor will be getting an interest rate of 1.05%, but we would
suggest the investor to take that much risk and purchase the share at current market
price.
Now, let us look at the table below which shows the conversion rate & price, the stock
return in % over 5 years and CAGR in % over 5 years, which would justify our
recommendation to the investors to not subscribe for the bond issue:
Stock
Per
Current
Return
Stock
Conversio
share
Market
Differenc
Price
120.00
125.00
130.00
n Rate
15.58
16.70
17.73
price
77.01
74.85
73.32
Price
47.45
47.45
47.45
e
29.56
27.40
25.87
in %
35.83
40.12
43.60
%
9.28
10.80
12.14
135.00
140.00
145.00
149.38
18.69
19.57
20.40
21.07
72.25
71.53
71.09
70.88
47.45
47.45
47.45
47.45
24.80
24.08
23.64
23.43
46.48
48.91
50.97
52.55
13.32
14.37
15.32
16.08
The table below shows the projected returns to the investor at various price points if
they purchase the stock at current market price and hold it for 5 years.
Stock Return over 5 CAGR
Stock Price
120.00
125.00
130.00
135.00
140.00
145.00
149.38
160.00
180.00
200.00
3.
Buy Price
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45
47.45
yrs
152.90
163.44
173.97
184.51
195.05
205.58
214.82
237.20
279.35
321.50
%
20.39
21.38
22.33
23.26
24.16
25.03
25.78
27.52
30.56
33.34
Now, even if the investor is keen to invest in the bonds issue then we suggest an
alternate investment strategy for the investor if in case he/she does not want to lose the
interest amount as well.
We propose the investor to invest $36,458 in treasury security for 5 years where the
interest rate is 2.88% per annum. By doing this the investor will get $1050 per year as
interest payment which is equivalent to the interest amount had he invested the whole