question archive Garden Company Limited (GCL) is a manufacturer of mobile phones

Garden Company Limited (GCL) is a manufacturer of mobile phones

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Garden Company Limited (GCL) is a manufacturer of mobile phones. Over the years, the company has been very successful in business. In 2016, GCL's shares were listed on the Hong Kong Stock Exchange. In managing the company's finance, the management and board of directors of GCL believe that significant financial assets should be retained by the company in order to capture opportunities and meet demands for strategic investments.

For the years ended 2018, 2019 and 2020, GCL reported income before interest and taxes of $400 million, $450 million and $380 million, respectively. The company had paid out only a small portion of its earnings as cash dividends each year. With the significant amount of cash flows the company had generated over the years, GCL has made several financial investments.

As at the financial year end of December 31, 2020, the financial assets held by GCL are shown in the following table. Cost or carrying amounts are year end balances of 2020 before adjustments for fair values (if applicable). Fair values are market values obtained at the end of financial years 2019 and 2020.

Investment (in $millions)

Cost or Carrying amount (2020)

Fair value (2019)

Fair value

(2020)

Cash and cash equivalents

50

40

50

Equity investment A

450

600

750

Equity investment B

275

225

300

Equity investment C

280

350

300

Debt investment D

800

750

500

Total

1,855

1,965

1,900

Details of equity and debt investments are as follow:

Equity investment A

Investment in 400,000 shares of Apple Company Limited, a public company with 2 million shares outstanding. Apple had net income of $15,000,000 for the financial year ending December 31, 2020, and declared and paid total dividends of $2,500,000 to its shareholders.

Equity investments B

Investment in various listed shares which the management believes are currently underpriced from time to time. During 2020, one of the investments, Orange Company Limited, was purchased and sold. The 1,500 shares of Orange's were purchased for $15,600,000 cash on March 31, and sold for $20,280,000 cash on September 1 in the same year. There was no other purchase or sale of equity investment in this category. Total dividends received from all equity investments was $12,000,000.

Equity investment C

Investment in Durian Company Limited. Durian has been a major supplier of GCL since 2014. The 150,000 shares of Durian were purchased by GCL for $200,000,000, upon request of Durian at the time of signing their first business agreement. Both GCL and Durian have benefited from the business relation over the years. On June 15, 2020, with the agreement of Durian, GCL sold 20% of its Durian shareholding for $75,000,000.

Debt investment D

Investment in Pineapple Corporation's 5-year bonds with face value of $1,000 million, and an annual coupon rate of 5% payable on June 30 and Dec 31. The market rate was 5% at the time of purchase. The purchase of bonds was to park idle cash until it matures after two years, when GCL will make a capital expenditure.

Apart from financial assets, GCL have non-financial assets with carrying value of $2.0 billion on the balance sheet.

On the liabilities side, as at the end of 2020, GCL had bonds outstanding in the amount of $1.5 billion with an interest rate of 8%. Of this amount, $300 million will be due for repayment on Mar 30, 2021. Other liabilities (accounts payable etc.) total $400 million which do not bear interest.

In connection with the upcoming redemption of the $300 million bonds, GCL is considering how it could, and should, fund the redemption. Selling one of the equity or debt investments is certainly an option. In doing so, GCL must be mindful of two provisions in the bond covenant, as violation of either provisions would allow bondholders the right to require immediate repayment of the debt. The two provisions are as follow:

1. GCL must maintain a debt-to-asset ratio under 50%, calculated at the end of each quarter. (Debt-to-asset ratio is calculated as all liabilities reported on the balance sheet divided by total assets.)

2. GCL must maintain an interest coverage ratio of 3:1, calculated at the end of each financial year. (Interest coverage ratio is calculated as income before interest and taxes divided by interest expense.)

Required:

(b) Record necessary journal entries for each category of investment to record the relevant transactions and fair value adjustments (if applicable) for the year 2020. Use one fair value adjustment account for equity investments, and one other for debt investments. Journalize all dividend income at the year end.

(c) Assume it is now March 2021. Advise GCL on how the $300 million debt repayment on March 30, 2021 should be funded, by selling which one of the equity or debt investments. Conduct a detailed analysis by evaluating the impact of each alternative on GCL's strategic position, current income, and balance sheet position. Illustrate with projections of debt-to-asset ratio and interest coverage ratio under each alternative. Where appropriate, use financial data of 2020 as the basis for projections.

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