Corporate Financial Restructuring Sample Questions with suggested answers _ Food & Tobacco, Inc (FAT) operates in two lines of business: Food with an estimated value of $10 billion and Tobacco with an estimated value of $15 billion Your task is to estimate the cost of equity Line of business Average levered Beta Average D/E ratio Food Industry 0.92 25% Tobacco Industry 1.17 50% Currently the firm has a D/E ratio of Tax rate for the firm is 40% Assume the current risk free rate is 6% and the market risk premium is 5.5% From the previous exercise assume that the company divests its Food division for $10 billion and uses the proceeds to repay debt a What will the new beta for the company be? b What will be the new beta if the company retains the cash and invests the proceeds in government securities instead of repaying debt? You have been provided the information on the after-tax cost of debt and cost of capital of Mirador, which has a 10% debt-to-capital ratio Estimate the after-tax cost of debt and cost of capital at a 20% debt-to-capital ratio The long-term Treasury bond rate is 7% Debt Ratio (‘000) 10% $ Debt $ 1,500 EBIT $ 1,000 Interest Expenses $ 120 EBIT Int Coverage Ratio 8.33 20% Extra Column Bond Rating AA Interest Rate 8.00% After-tax Cost of Debt 4.80% Beta 1.06 Tax rate 40% Cost of Equity 12.83% Cost of Capital 11.78% The interest coverage ratios, ratings and spreads are as follows: Coverage Ratio Rating Spread over Treasury > 10 AAA 0.30% -10 AA 1.00% 5-7 A 1.50% 3-5 BBB 2.00% 2- BB 2.50% 1.25 - B 3.00% You have been asked to analyze the capital structure of Stevenson Steel The company has supplied you with the following information: • There are 100 million shares outstanding, trading at $ 10 a share • The firm has debt outstanding of $ 500 million, in market value terms • The beta for the firm currently is 1.04, the risk free rate is 5% and the market risk premium is 5.5% • The firm’s current bond rating is A; the default spread for A rated bonds is 1.5% • The effective tax rate is 20%, but the marginal tax rate is 40% a Estimate the current cost of capital for Stevens Steel b Now assume that you have computed the optimal debt-to-capital ratio to be 50% If the pre-tax cost of debt will rise by 0.25% if it moves to the optimal, estimate the new cost of capital at the 50% DCR The following are the details of two potential merger candidates, Andrews and Barnes Revenues Cost of Goods Sold (w/o Depreciation) Depreciation Tax Rate Working Capital Market Value of Equity Outstanding Debt A $4,620 87.50% $200.00 35.00% 10% of Revenue $2,000 $160 B $3,125 89.00% $74.00 35.00% 10% of Revenue $1,300 $250 Both firms are expected to grow 5% a year in perpetuity Capital spending is expected to be offset by depreciation The beta for both firms is 1, and both firms are rated BBB, with an interest rate on their debt of 8.5% (the treasury bond rate is 7%) As a result of the merger, the combined firm is expected to have a cost of goods sold of only 86% of total revenues The combined firm does not plan to borrow additional debt a Estimate the value of A, operating independently b Estimate the value of B, operating independently c Estimate the value of the combined firm, with no synergy d Estimate the value of the combined firm, with synergy e How much is the operating synergy worth? Varum, a chip designer, is concerned about its burden of debt and is looking for a way out Based on last year's performance, management estimates EBIT at $15 million Discussions with the banks show that in order to avoid violating covenants a minimum EBIT interest coverage ratio of must be maintained Currently US treasurys pay 5% Varum currently has debt of 60 million What is its debt capacity? Use the table below For smaller and riskier firms If interest coverage ratio is > ≤ Rating is Spread is -100000 0.499999D 14.00% 0.5 0.799999C 12.70% 0.8 1.249999CC 11.50% 1.25 1.499999CCC 10.00% 1.5 2.5 3.5 4.5 7.5 1.999999B2.499999B 2.999999B+ 3.499999BB 4.499999BBB 5.999999A7.499999A 9.499999A+ 8.00% 6.50% 4.75% 3.50% 2.25% 2.00% 1.80% 1.50% Varum continues to struggle with a too much debt It expects to resume a growth rate of 7% soon, but now must renegotiate its capital structure Based on last year's performance, management estimates EBIT at 11m Discussions with the banks show that in order to extend credit, they insist on a minimum EBIT interest coverage ratio of Currently US treasurys pay 5% Cost The company now has debt of 120m paying 8.5% 10.2 Equity is estimated to be worth 30m Coverage ratio: What is the debt worth? 1.08 What is the company's debt capacity? What new capital structure could be negotiated with the banks? Varum has succeeded in improving EBIT Now management is considering doing a leveraged recap Currenty the company has debt of $48m Management estimates EBIT at $32m Banks' minimum EBIT interest coverage ratio: 2.2 Currently US treasurys pay 4% The estimated value of the firm is $250m The firm's tax rate is 30% What is the company's debt capacity? What should they do? What effect would this have on the share price? Amtrak is considering splitting itself up into two parts – the railroad business and the station management business The split would be done by making a tax-free distribution of shares in a new company, Amstation, to all Amtrak shareholders This would save Amtrak $50 million next year in administrative costs Before bringing this proposal to the Board, management would like to demonstrate that shareholders will be better off after the split Evaluate the proposal, based on the following estimates: EBITDA Tax rate $ Existing Estimated Amtrak Amrak sans stations 475.00 $ 375.00 $ 30% 30% Estimated Amstation 100.00 32% Beta Growth rate Equity Debt Risk Free Mkt Risk Premium Debt spread 0.8 3.50% € 6,500 € 6,000 4% 5.5% 2.5% 0.85 2.50% € 5,500 € 5,000 4% 5.5% 2% 0.7 4.5% € 1,000 € 1,000 4% 5.5% 4% 10 Zombie Inc., a manufacturer of Voodoo dolls for medicinal purposes, is being forced into involuntary liquidation Ernst & Young is brought in to handle the sale of assets and distribution of proceeds E&Y estimates that accounts receivable can be collected for 80% of amounts due, inventory can be sold at 50% of book, and the market value of PPI is about 75% of its depreciated value The liquidators' fees are 500,000 and other bankruptcy-related cost amount to $700,000 Federal taxes due are $2 million, and a wrongful death lawsuit is being brought against the company in Haiti How much can the banks expect to get? Assets Cash Accounts receivable Other short term assets Property, plant and equipment Total Liabilities 100000 Accounts payable 900000 Short term secured debt 5100000 Long term bank debt 8000000 Shareholders equity 14100000 Total 1000000 100000 9000000 4000000 14100000 Solutions Unlevered Beta for Food Business = 0.92/(1+(1-.4)(.25)) = 0.8 Unlevered Beta for Tobacco Business = 1.17/(1+(1 - 4)(.5)) = 0.9 Unlevered Beta for the Company = 0.8 (10/25) + 0.9 (15/25) = 0.86 Levered Beta for the Company = 0.86 (1 + (1-.4)(1.00)) = 1.376 Cost of Equity for the Company = 6% + 1.376 (5.5%) = 13.57% 2.a Unlevered Beta after sale = 0.90 (Food business is sold off) Debt after divestiture = (12.5 billion - 10 billion) = 2.5 billion Equity after divestiture = 12.5 billion Debt/Equity Ratio after the transaction = 2.5/12.5 = 0.2 New Levered Beta = 0.90 (1 + (1-.4) (.2)) = 1.008 2.b Unlevered Beta after sale = 0.90 (15/25) + 0.00 (10/25) = 0.54 Levered Beta after sale = 0.54 (1 + (1-.4) (1.00)) = 0.864 Debt Ratio 10% 20% Extra Column $ Debt $ 1,500 3000 3000 EBIT $ 1,000 1000 1000 Interest Expenses $ 120 240 270 Interest Coverage Ratio 8.33 4.16 3.70 Bond Rating AA BBB BBB Interest Rate 8.00% 9% 9% ( spread changes, so recalculate Interest until rating remains constant) After-tax Cost of Debt 4.80% Beta 1.06 Cost of Equity 12.83% Cost of Capital 11.78% Bond Rating = BBB Interest Rate = 9.00% After-tax Cost of Debt = 5.40% Unlevered Beta = 1.06/(1+(1-0.4)(.1111)) = 0.993756211 Beta at 25% D/E Ratio = 0.99(1+0.6(.25)) = 1.142819643 Cost of Equity = 7% + 1.14 (5.5%) = 13.27% Cost of Capital = 5.40% (.2) + 13.27% (.8) = 11.70% a Current Cost of Equity = 5% + 1.04*5.5% = 10.72% Current cost of debt = (5 + 1.5) * = 3.90% Current cost of capital = 10.72% (.67) + 3.9% (.33) = 8.47% b New debt to capital ratio = 50% New debt to equity ratio = 100% Unlevered Beta = 1.04 / (1+ (.6 * 5) = 0.8 New Beta = 1.28 New cost of equity = 12.04% New after-tax cost of debt = 4.05% New Cost of capital= 8.05% A B Without synergy With Synergy Revenues - COGS - Deprecn = EBIT EBIT (1-t) - Δ WC FCFF $4,620 $4,043 $200 $378 $245 $22 $223 $3,281 $2,920 $74 $287 $187 $16 $171 $7,901 $6,963 $274 $664 $432 $38 $394 $7,901 $6,795 $274 $832 $541 $38 $503 Cost of Equity Cost of Debt WACC 12.50% 5.53% 11.98% 12.50% 5.53% 11.38% 12.50% 5.53% 11.73% 12.50% 5.53% 11.73% Firm Value $3,199 Firm Value = FCFF1/(WACC - g) $2,681 $5,879 $7,479 Synergy Gain = $7479 - $5879 = $1,600 Question EBIT Min EBIT int coverage ratio Interest capacity Interest rate $ 15 $ 11.50% Debt capacity $ 65 Question Estimating borrowing capacity Possible capital structure Given: EBIT Min EBIT int coverage ratio Interest capacity $ Interest rate Debt capacity $ Debt Mezzanine Equity Total financing 11 Before 120 After 48 30 30 78 150 11.50% 48 Pre-restr debt value: Banks might takeDebt Equity Value 61.8 48 20 68 Question Estimating borrowing capacity Preliminary capital structure Given: EBIT $ Min EBIT int coverage ratio Interest capacity $ Interest rate Debt capacity $ Debt Mezzanine Equity Total financing $ 139 $ $ 111 250 Dividend? Tax shield gain? PV tax shield gain? Assumes growth WACC $ 32 2.20 15 10.50% 139 Equity value: Shares $ Dividend $ Tax shield $ Gain of Question Breaking Up is Hard EBITDA Tax rate Beta Growth rate Equity Debt $ Existing Estimated Amtrak Amrak sans stations 475.00 $ 375.00 $ 30% 30% 0.8 0.85 3.50% 2.50% € 6,500 € 5,500 € 6,000 € 5,000 Estimated Amstation 100.00 32% 0.7 4.5% € 1,000 € 1,000 $ 91 2.9 39 3% 10.50% $ 241 111 91 39 19% Risk Free Mkt Risk Premium Debt spread Re Rd WACC Enterprise PV Equity PV Additional Gains/losses 4% 5.5% 2.5% 8.40% 6.50% 6.55% € 16,108 € 10,108 Choice € 10,108 4% 5.5% 2% 8.68% 6.00% 6.54% € 9,505 € 4,505 € 1,267 4% 5.5% 4% 7.85% 8.00% 6.65% € 4,872 € 3,872 €0 € 9,644 Question 10 Assets Cash Accounts receivable Other short term assets Property, plant and equipment Total Book Liquidation Liabilities 100000 100000 Accounts payable 900000 720000 Short term secured debt 5100000 2550000 Long term bank debt 8000000 6000000 Shareholders equity 14100000 9370000 Total Total available 9370000 Claim Get Balance Secured creditors 100000 100000 9270000 Bankruptcy costs 1200000 1200000 8070000 Taxes 2000000 2000000 6070000 Unsecured creditors 10000000 6070000 A/P 1000000 607000 Banks 9000000 5463000 1000000 100000 9000000 4000000 14100000 ... operating independently c Estimate the value of the combined firm, with no synergy d Estimate the value of the combined firm, with synergy e How much is the operating synergy worth? Varum, a chip... cost of equity = 12.04% New after-tax cost of debt = 4.05% New Cost of capital= 8.05% A B Without synergy With Synergy Revenues - COGS - Deprecn = EBIT EBIT (1-t) - Δ WC FCFF $4,620 $4,043 $200... have been asked to analyze the capital structure of Stevenson Steel The company has supplied you with the following information: • There are 100 million shares outstanding, trading at $ 10 a share