Debt Contagion and Financial Issues at Ahmad Zaki ...
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CUeJAR Volume 3 | Issue 2 | 2021
City University eJournal of Academic Research (CUeJAR)
e-ISSN : 2682-910X
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Received: 9th March 2021
Revised: 30th March 2021
Accepted: 25th April 2021
Debt Contagion and Financial Issues at Ahmad Zaki Resources Berhad
Azizah Md Nor
Faculty of Business and Management, City University, Malaysia ([email protected])
Abstract
Introduction: The case study takes place at Ahmad Zaki Resources Berhad, (AZRB) which
is one of the construction companies in Malaysia. Purpose of the study is to evaluate the
capital structure of AZRB to understand the capital structure decisions of the company
and to know the impact of capital structure decisions on the profitability and performance
of the company.
Methodology: The author evaluated the composition of the capital structure used by
AZRB during the period of year 2014 to 2018 so as to understand the company’s planning
and its patterns of financing. The case study used Debt Ratio, Debt to Equity Ratio and
Interest Coverage Ratio on the company’s five years annual reports.
Result and Discussion: Results show that the increasing level of debt in the company
balance sheet was tremendous and it diminishing the company’s net worth and has taken
its debt-equity ratio to an unsustainable limit.
.
Conclusion and Recommendation: Theoretical and practical implications are introduced
as well as suggestions for future research.
Keywords: Capital Structure, Debt and Equity Financing, Leverage, Ownership Structure.
1.0 Introduction
Capital structure refers to a company’s outstanding debt and equity. It allows a
firm to understand what kind of funding the company uses to finance its overall
activities and growth. The financing policy chosen, most of times, refer to the
policy that has been specified by the management in financing their investments.
In other words, it shows the proportions of debt and equity (common or
preferred equity) in the funding. A company's proportion of short- and long-term
debt is considered when analyzing capital structure.
When analysts refer to capital structure, they are most likely referring to a
firm's debt-to-equity (D/E) ratio, which provides insight into how risky a company
is. Usually, a company that is heavily financed by debt has a more aggressive
capital structure and therefore poses greater risk to investors.
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The purpose of capital structure is to provide an overview of the level of the
company’s risk. As a rule of thumb, the higher the proportion of debt financing a
company has, the higher its exposure to risk will be. This risk, however, may be
the primary source of the firm's growth . Most companies will make effort to make
an optimal financing combination of debt and equity or better known as the target
capital structure.
The cost of capital which is the combined costs of all the company’s financing
resources is known as Weighted Average Cost of Capital (WACC). It is the
average cost after tax for each capital resources that is used by the company to
finance its projects (Rhyne & Brigham, 2006).
2 Literature review
Many empirical studies have looked into the factors that influence capital structure
choice from various perspectives and in various environments connected to
established and emerging economies (Lei et al., 2021; Khalifa et al., 2021;
Khalifa, Trung and Hossain, 2021; Alghfeli et al., 2021; Hossain et al., 2020;
Alneadi et al., 2020; Alharthi et al., 2020; Almatrooshi et al., 2020; Khalifa, 2020;
Khalifa, 2019; Jassem Al-Ameri, Bhaumik and Khalifa, 2019; Alghfeli et al.,
2019; El-Aidie, Alseiari and Khalifa, 2021; Almatrooshi et al., 2021). Miller and
Modigliani (1958) investigated whether the firm's value was independent of its
capital structure, and that the advantages and costs of debt were set off, with no
effect on the firm's value. The hypothesis is based on a number of unreasonable
assumptions, including neglecting the effects of taxes, equity transaction fees, and
bankruptcy expenses. However, it serves as a beginning point for understanding
the capital structure and the factors that influence financing mix decisions.
Titman and Wessels (1988) investigated the explanatory power of certain
current debt equity ratio ideas. They discovered that debt financing was negatively
associated to a firm's originality in terms of its type of operation. The results were
consistent with current ideas and suggested that transaction costs could be a
determining factor in capital structure decisions.
Cassar and Holmes (2003) conducted another study to test the static trade off
theory and pecking order theory on the attributes of size, tangibility of asset,
profitability of firm, growth, and risk.
The firm's debt funding was influenced less by size and risk. The static trade-
off, pecking order, and agency cost theories all agreed with these findings. While
Rajan and Zingales (1995) pointed out that parameters linked to firm leverage in
the United States by previous studies have a comparable association in other
countries.
D Vasiliou et al. (2003) found that enterprises with large fixed asset
investments had a greater leverage ratio than smaller firms in a subsequent
investigation. The study supported both the trade-off and pecking order theories. T.
Mitton (2007) elucidated the emerging market's proclivity towards debt financing.
Cespedes et al. (2009) explained the behaviour of enterprises in seven Latin
American nations in their study. They discovered that ownership-oriented
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businesses preferred equity financing, which had smaller tax benefits and higher
bankruptcy costs. According to Jong et al. (2008), the debt equity ratio is linked to
a number of country-specific characteristics such as bond market development,
creditor rights protection, and GDP growth rate. Although many international
scholars have looked into the factors that influence a company's decision on debt
and equity ratios in developed countries, few have looked into companies in
emerging countries.
2.1 Case Review
2.1.1 Business Activities and Development
Ahmad Zaki Resources Berhad (AZRB) is an investment holding company,
which engages in the civil and structural works contracting and provision of
management services. AZRB was incorporated on 26 May 1997, and was listed
on Bursa Malaysia since 1999. From its modest beginnings, established as Ahmad
Zaki Sdn Bhd (AZSB) in 1982, AZRB has earned its reputation as the Builder of
Award-winning Landmarks and Infrastructure Projects in Malaysia. AZRB
operates through the following segments:
Engineering and construction segment refers to the civil and structural
works.
Concession segment includes concession and assets managements.
Oil and gas segment deals with marine fuels, lubricants and petroleum
based-products.
Plantation segment refers to the production of crude palm oil and kernel.
Property segment which responsible for the property development, hotel
operation and facilities management.
AZRB consolidated annual revenue exceeded the Billion Ringgit mark for the
first time in 2016. Engineering and construction (E&C) contributed 93% of this
success. E&C project excellence spanning across various landmark projects such
as Menara Kerja Raya and Masjid Wilayah Persekutuan Kuala Lumpur. Other
E&C projects include on-going mega scale such as the MRT Sungai Buluh-
Serdang-Putrajaya line, Viaduct Package V202 and East Klang Valley
Expressway.
AZRB today is involved in business activities such as:
Oil and Gas – as the operator of Tok Bali Supply Base
Property development and facilities management (currently the concession
holder for IIUM teaching hospital in Kuantan for 21 ½ years period)
Oil Palm Plantation – spanning across a sizable 8,200 hectare in West
Kalimantan
Expressway – as the concession holder for East Klang Valley Expresswa
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2.1.2 Company Results and Financial Highlights
The year 2018, has been a year of tremendous growth of the Group. The
Group showed significant growth in revenue recorded with an increase of 27.9%
from the financial year ended 2017 (Y2017). The recorded revenue of RM1.23
billion (compare Y2017: 960.6 million) is the highest ever recorded by the Group
in its 36-year history.
Unfortunately, the Group’s profitability did not increase in line with that of
revenue recorded. One of the significant impacts to the Group’s profitability was
the unrealized foreign exchange loss recorded by the Plantation Division of
RM19.7 million, which severely impacted its profitability and overall financial
performance. Adding further to the woes of the Plantation Division were the low
crude oil (CPO) prices during the whole 2018, especially when compared to 2017.
Whilst there was the continuous growth in revenue for the Plantation Division, the
loss before tax recognized was significantly worse in Y2018, with RM29.6 million
as compared to 2017 with 18.1 million losses before tax reported.
Another factor in the lower profits for the Group was the recognition of full
maintenance costs at its IIUM Medical Centre Concession (PenMedic) from May
2018 onwards following the expiry of the defect liability period for PenMedic.
Taking all this into account, the Group recorded a net profit of RM8.6 million in
2018 as compared to RM2.7 million in 2017.
As for in Y2016, It was a year where the construction division helped propel
the Group to reach a significant mark and milestones in the Group’s financial
history. Both the Group and construction division passed billion Ringgit mark in
terms of revenue with a recorded revenue of RM1.2 billion (2015: RM714.97
million and 2014: RM662,358 million).
The construction division retained its position as the Group’s primary
generator of revenue and profit, as is befitting for the core business since
inception. This segment accomplished a new milestone in 2016 with a record
RM1.6 billion in new contract wins, attesting AZRB competitiveness in tenders
and customers’ recognition of their strong expertise encompassing the full range of
design to development of iconic buildings and infrastructure.
The construction division’s year of achievement started off with the award by
the International Islamic University of Malaysia (IIUM) for the supply of
additional medical equipment for the IIUM Medical Centre. In the meantime, the
construction division successfully completed the construction of the IIUM Medical
Centre. In April 2016, the construction division has been awarded by MRT Corp
for the Mass Rapid Transit (MRT) Sungai Buloh-Serdang-Putrajaya (SSP) Line for
a project known as ‘Package V202’ for a total value of RM1.44 billion.
2.1.3 Capital Structure and Financial Performance
A company’s capitalization describes the composition of a company’s
permanent or long-term capital which consists of a combination of debt and
equity. From a technical perspective, the capital structure is defined as the careful
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balance between equity and debt that a business uses to finance its assets, day to
day operations and future growth. Therefore, capital structure ratios are very
important to analyze the financial statements of any company.
There are four important effects of financial leverage:
1. Increases expected rates of return on equity and expected EPS
2. Increases risk of equity: both variance and beta
3. Increases the probability of bankruptcy and expected bankruptcy costs
4. Increases the interest tax shield
Below are two financial ratios that reflected the companies’ capital structures.
Debt to Equity Ratio
The debt to equity ratio is the most important of all capital adequacy ratios. It
shows the relation between the portion of assets financed by the creditors and the
portion of assets financed by shareholders. Hence, it would tell the shareholders as
well as debt holders the relative amounts they are contributing to the capital.
Debt Ratio
The debt ratio is the second important ratio when it comes to gauging the
capital structure and solvency of the company. It tells the investment community
the amount of funds that have been contributed by creditors instead of the
shareholders. According to the previous literature (see Rajan and Zingales (1995))
there are four factors that identifies as the major determinants of firms' debt ratios:
size, asset tangibility, growth, and profitability. In particular, size and the
proportion of tangible assets are highly significant and positively related to debt
ratios, while profitability and growth opportunities, as proxies by the ratio of
capital expenditures to total assets and growth in sales, are highly significant and
negatively related to debt ratios. (Margaritis & Psillaki, 2010)
2.1.4 Capital Structure in AZRB
After the analysis, I considered AZRB as a leveraged company because the
business relies more of long-term debt financing which are loans and also
borrowings. However, when the interest costs are high and the volume is much, it
is advisable for the company to avoid debts financing and instead go for equities
issuance.
Generally, in most construction sectors, plants and equipment are financed
under the leasing arrangements. This has obviously shown in AZRB financial
statements where its debts ratios are shown in below table.
Table 1 : Debt Ratio from year 2014 to 2018
Ratio Formula
2018
2017
2016
2015
2014
Debt Ratio
89%
88%
89%
80%
70%
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For the past five years, it is seen that AZRB used debts as its capital financing
and only 11% of its capitals were financed by equities. The ratios were stagnant
from Y2016 to Y2018. Further analysis on the AZRB debt to equity ratio indicates
that AZRB debt to equity ratio keeps increasing from 126% in Y2014 to 311% in
Y2018.
Table 2 : Debt to Equity Ratio from 2014 to year 2018
Ratio Formula
2018
2017
2016
2015
2014
Debt to Equity Ratio
311% 248%
285%
184%
126%
This indicate that AZRB had invested huge amount in its capital using
leverage financing and only small percentage of amount through its equities
issuance. The increase in the leverage is back up by its billions of contracts won
over the years due to AZRB recognition on its strong expertise to most of their
customers.
According to Harris and Raviv (1991, page 334), the available studies
“generally agree that leverage increases with fixed assets, non-debt tax shields,
growth opportunities, and firm size and decreases with volatility, advertising
expenditures, research and development expenditures, bankruptcy probability,
profitability and uniqueness of the product.” (Frank & Goyal, 2009)
3. Case Analysis
AZRB is an investment holding company which engages in civil and
structural works contracting and provision of management services. It was
incorporated on 26 May 1997 and was listed on Bursa Malaysia Berhad since
1999. AZRB has earned its reputation as the Builder of Award-winning
Landmarks and Infrastructure Projects in Malaysia. AZRB’s engineering and
construction division contributed 93% of this success.
Other business activities involve are oil and gas, property development, oil
palm plantation and expressway. AZRB’s Group results in year 2016, had passed
billion Ringgit mark in terms of revenue. The construction division retained its
position as the Group’s primary generator of revenue and profit.
AZRB relies on long-term creditor supplied funds to run its construction
business. This is shown from the company debt to equity ratio. AZRB’s debt to
equity ratios from 2014 was greater than 100% and the figure kept increasing to
310% in Y2018. The industry ratio reads at 43% (Attachment 5). This indicate
that AZRB’s assets were mostly financed by debts and its frightening.
Besides getting loans from the private loans, for instance banks, AZRB plants
and equipment were mostly financed under the lease arrangements. This is one of
the reasons why the interest cost of AZRB is extremely high.
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Another reason of this high interest costs was due to the public loan obtained
from public bonds example SUKUK. In January 2016, AZRB has made its first
issuance of RM1 billion SUKUK murabahah programme to fund the construction
of the East Klang Valley Expressway (EKVE). The proceeds raised from the
issuance would be used by EKVE to, among others, part-finance and reimburse all
costs associated with the development, design, construction and operations of the
EKVE.(Attachment 6)
Looking at its interest payment it shows that AZRB spent lots of its earnings
to pay the interest costs. In Y2018, over RM60 million was spent to the interest
expense and this figure is so alarming.
Table 3 : Interest payment expenses from year 2014 to 2018
Expenses Y2018
‘000
Y2017
‘000
Y2016
‘000
Y2015
‘000
Y2014
‘000
Interest payment 66,050 55,281 52,566 46,566 21,692
Further analysis on AZRB interest coverage ratio reveals the following result.
Table 4 : Interest Coverage Ratio from year 2014 to year 2018
Ratio Y2018
‘000
Y2017
‘000
Y2016
‘000
Y2015
‘000
Y2014
‘000
Interest Coverage Ratio 28,106/
66,050
=0.42
53,117/
55,281
=0.99
51,730/
52,566
=0.98
72,821/
46,566
=1.56
43,526/
21,692
=2.00
From the table we could summarize that AZRB capability to serve his interest
is decreasing from Y2014 to Y2018. In Y2018, it looks that AZRB EBIT could not
cover its interest payment for the year and this is one of the financial distress
indicators. The interest amount of RM66,050,000 for the year is too large and it’s a
signal that AZRB should think of a way to settle their loans fast. Having not
receive the finance income of RM62.761 million for the Y2018, AZRB is not
capable to pay its interest costs and would be on loss of (RM37,944).
Another reason on why AZRB maintaining its issuance of new share despite
being a public listed company is because AZRB does not want to lose its control
over the company. One fundamental difference between private and public firms is
their owner ship structure and hence the degree to which control is valued by their
shareholders. Where conflicts of interest exist, agency problems can arise and
control is valuable. Therefore, firms controlled by a major shareholder should be
reluctant to use equity financing when doing so causes the controlling shareholder
to risk losing control (Brav, 2009).
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AZRB share capital for the Y2018 stood at 197.536 million, and not much
changes seen in its share capital in Y2017. In Y2017 the share capital was at
RM197,478 to compare with RM120.885 million in Y2016, where there was an
increase of 63% from Y2016 and Y2015.
Table 5 : Share Capital and Reserve year 2014 to year 2018
Capital 2018
‘000
2017
‘000
2016
‘000
2015
‘000
2014
‘000
Share capital
197,536
197,478
120.885
120,885
120,885
Reserve
263,945
248,252
244,031
217,900
207,863
Looking at the Directors indirect interest (deemed interest) as at 29/3/2019, we
noticed that Dato Sri Haji Wan Zaki holds RM321.927 million shares of AZRB.
He is the majority owner of AZRB. Issuing of new shares may result on the loss of
majority shares by Dato Sri Wan Zaki. Perhaps Dato Sri doesn’t want to dilute his
controlling interest by issuing new shares.
However, due to the high interest costs incurred, AZRB has no alternative
than to issue the new share issuance. Latest share issuance was done on 29/3/2019
and the paid up and issuance capital was then at RM600 million shares. With the
new share issuance, Dato Sri Wan’s interest in shares has reduced as tabulated
below:
Table 6 : Share Interest of Dato Sri Wan.
Date Direct Interest Deemed Interest %
30/3/2016 3,821,975 287,958,188 59.73
31/7/2017 3,821,975 285,958,188 59.32
30/3/2018 3,821,975 285,958,188 53.94
29/3/2019 4,747,471 321,927,959 53.82
Based on the above percentage hold above, we could summarize that despite
the burden on the interest costs payment, as much as possible, Dato Sri is ensuring
to hold on the majority interest and not to dilute its controlling to the public
shareholders.
Ideally, to get RM 1 billion fund by new share issuance, instead of borrowing
RM1 billion from public or private, AZRB has to issue 2.5billion shares (based on
today’s share price, 2/8/2019 @RM0.40 per share – Attachment 3&4).
For instance, taking the Y2016 capital record, Dato Sri interest will be reduced
to 9.63 i. e. 287m /(480m+2500m). As such, shares of Dato Sri will reduce from
59.73% to 50.1%% and that shows that he may not hold more than 51% of
majority shares anymore. (Attachment 8)
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5. Conclusion
Managers of large firms are responsible to provide continuous service and
must refrain from using leverage to the point where the firm’s long-run viability is
endangered. In this case study, it is obvious that AZRB total debt leverage is so
alarming when the non-current liabilities were over RM2.5billion in Y2018 and its
interest expenses is RM66million. Trade Off Theory Modigliani and Miller
indicates that interest rates rise as debt/asset ratio increases.
One of the reasons of this high interest expense could be due to the SUKUK
bond they made to finance the EKVE construction, and anticipating that they will
get the payment back and pay back the interest when EKVE launch their highway
on 9 September 2019. However, latest news confirmed that EKVE was granted an
extension of time of 315 days, with a new completion date of 20 July 2020.
(Attachment 9). If this is going to happen, AZRB will suffer more in terms of its
interest expenses.
Analysis shows that the company’s debts keep on increasing and to one extend
we see that the private loans are no longer keep to offer them borrowings. This
could be seen in their almost stagnant volume of non-current liabilities from
Y2016 to Y2018 (RM2.136b, RM2.368b and RM2.533b). And perhaps that the
reason AZRB started to issued out its new shares in 30/3/2018 and 29/3/2019?
However, what actually refrain AZRB from quickly switch to the optimal capital
structure? Are they trying not to dilute their controlling to the public shareholders?
Further observation, we also noticed that AZRB shareholders are not happy
with the company. Shareholders started selling their shares and the shares price has
dropped even though AZRB managed to secure the EKVE highway contract from
the Government. Share price has dropped to RM0.39 cents as at 03/08/2019. In
January 2019, price drop to RM0.30 against the par value of RM0.25. This may
due to the public release that the EKVE highway completion date been extended to
September 2019. Something to ponder here is “what if the share price keep
dropping?”
Author is of the opinion that the management of AZRB had taken the action
that provides clues to the investors about how management views the firm’s
prospects and as a result the Reserve Borrowing Capacity increase. This can be
seen through-out their ability to borrow money at a reasonable cost with the public
loan (SUKUK bond), when the good investment opportunities arise on funding the
construction highway EKWE. (Signaling Theory)
The decision to issued out shares are good way to ease out the debt leverage
burden and to optimize their leverage structure, however, it should be done earlier
when the company is not too burden with its debt leverage. They should consider
re-structuring their capital and not just relying too much on debt long before they
issued the SUKUK bond.
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ATTACHMENT 1
Statement of Financial Position Group 2018
RM’000
Group 2017
RM’000
Group
2016
RM’000
Group
2015
RM’000
Group
2014
RM’000
Assets
Non Current Assets
:
Property, plant and
equipment
Prepaid lease
payments
Land held for
development
Biological assets
Intangible assets
Concession service
assets
Goodwill
Investment in
subsidiaries
Investment in
associates
Interests in joint
ventures
Available-for-sale-
investments
Deferred tax assets
Trade and other
receivables
570,113
22,577
56,995
77
20,995
1,238,196
41,781
-
2,805
34
116
35,474
640,992
306,870
23,869
36,130 198,665
22,620 829,873
41,781
-
165
34
116
27,294
625,536
285,064
20,860
38,630
173,055
41,060
398,071
36,490
-
165
34
116
22,712
704,236
114,671
7,800
24,228
140,457
-
39,920
6,158
-
165
3,104
116
31,517
108,306
96,274
8,046
8,958
124,969
16,410
-
6,158
-
165
448
116
24,695
87,591
Total non-current
assets
2,964,253 2,112,953 1,720,493 476,442 373,829
Current Assets
Inventories
Property
development costs
Current tax assets
Trade and other
receivables
Other investments
Cash and deposits
19,393
17,480
11,339
640,992
164,338
622,896
19,240 15,843
10,898 798,537
699,510
281,338
12,222
19,366
11,782
786,517
823,856
190,052
13,450
23,473
8,858
1,036,818
-
153,096
13,176
11,943
6,519
660,710
-
102,840
1,843,795
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Nor, 2021 99
Total current assets 1,476,438 1,825,366 1,235,695 824,354
Total Assets 4,440,691 3,938,319 3,564,288 1,712,137 1,198,183
Equity
Share Capital
Reserves
197,536
263,945
197,478
248,252
120,885
244,031
120,885
217,900
120,885
207,863
Equity attributable
to owners of the
Company
461,481 445,730 364,916 338,785 328,748
Non-controlling
interests
11,521 16,941 23,431
2,324
3,994
Total equity 473,002 462,671 388,347
341,109
332,741
Liabilities
Loans and
borrowings
Employee benefits
Deferred tax
liabilities
Trade and other
payable
2,308,904
3,373
82,488
138,339
2,171,467 3,029
77,426 116,217
2,000,353
2,836
75,097
57,800
690,662
-
2,324
56,291
403,810
1,721
45,854
-
Total non-current
liabilities
2,533,104
2,368,139
2,136,086
749,277
451,385
Loans and borrowings
Trade and other payables
Current tax liabilities
317,491
1,098,072
19,022
257,260
831,187
19,062
187,424
852,127
304
159,149
457,442
5,160
82,757
325,954
5,345,532
Total current liabilities
1,434,585
1,107,509
1,039,855
621,751
414,056
Total liabilities
3,967,689
3,475,648
3,175,941
1,371,028
865,441
Total equity and liabilities
4,440,602
3,938,319
3,564,288
1,712,137
1,198,183
ATTACHMENT 2
Computation of Capital Structure Ratios
Ratio Formula
2018
2017
2016
2015
2014
CUeJAR Volume 3 | Issue 2 | 2021
Debt Contagion and Financial Issues
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Debt to Equity Ratio
= Long Term Liabilities / Total
Equity x 100
2,533,104/
473,033
=5.35
X 100
=535%
2,368,139/
462,671
= 5.12
X 100
= 512%
2,136,086/
388,347
= 5.5
x 100
= 550%
749,277/
341,109
= 2.19
x 100
= 219%
451,385/
332,741
= 1.35
x 100%
= 135%
Debt Ratio
= Total Liabilities / Total
Assets x 100
3,967,689/
4,440,691
=0.89
X 100
= 89%
3,475,648/
3,938,319
= 0.88
X100
= 88%
3,175,941/
3,564,288
= 0.89
x 100
= 89%
1,371,028/
1,712,137
= 0.80
x 100
= 80%
865,441/
1,198,182
= 0.7
x 100
= 70%
ATTACHMENT 3
ATTACHMENT 4
CUeJAR Volume 3 | Issue 2 | 2021
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ATTACHMENT 5
ATTACHMENT 6
CUeJAR Volume 3 | Issue 2 | 2021
Debt Contagion and Financial Issues
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ATTACHMENT 7
ATTACHMENT 8
ATTACHMENT 9