Corporate Financial Restructuring

Sample Questions with suggested answers

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1. 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 1. Tax rate for the firm is 40%. Assume the current

risk free rate is 6% and the market risk premium is 5.5%.

2. 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?

3. 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% 20% Extra Column

$ Debt $ 1,500

EBIT $ 1,000

Interest Expenses $ 120

EBIT Int. Coverage Ratio 8.33

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%7 -10 AA 1.00%5 - 7 A 1.50%3 - 5 BBB 2.00%2- 3 BB 2.50%1.25 - 2 B 3.00%

4. 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

5. The following are the details of two potential merger candidates, Andrews and Barnes.

A BRevenues $4,620 $3,125Cost of Goods Sold (w/o Depreciation) 87.50% 89.00%Depreciation $200.00 $74.00Tax Rate 35.00% 35.00%Working Capital 10% of Revenue 10% of RevenueMarket Value of Equity $2,000 $1,300Outstanding Debt $160 $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?

6.

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 2 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 firmsIf 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 1.999999B- 8.00%2 2.499999B 6.50%

2.5 2.999999B+ 4.75%3 3.499999BB 3.50%

3.5 4.499999BBB 2.25%4.5 5.999999A- 2.00%

6 7.499999A 1.80%7.5 9.499999A+ 1.50%

7.

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 11mDiscussions with the banks show that in order to extend credit, they insist ona minimum EBIT interest coverage ratio of 2Currently US treasurys pay 5% CostThe company now has debt of 120m paying 8.5% 10.2Equity is estimated to be worth 30m Coverage ratio:What is the debt worth? 1.08What is the company's debt capacity?What new capital structure could be negotiated with the banks?

8.

Varum has succeeded in improving EBITNow management is considering doing a leveraged recap

Currenty the company has debt of $48mManagement estimates EBIT at $32mBanks' minimum EBIT interest coverage ratio:2.2Currently US treasurys pay 4%The estimated value of the firm is $250mThe 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?

9.

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:

Existing Estimated Estimated  Amtrak Amrak sans stations AmstationEBITDA $ 475.00 $ 375.00 $ 100.00 Tax rate 30% 30% 32%

Beta 0.8 0.85 0.7Growth rate 3.50% 2.50% 4.5%Equity € 6,500 € 5,500 € 1,000Debt € 6,000 € 5,000 € 1,000Risk Free 4% 4% 4%Mkt Risk Premium 5.5% 5.5% 5.5%Debt spread 2.5% 2% 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 assetsand distribution of proceeds. E&Y estimates that accounts receivable can be collectedfor 80% of amounts due, inventory can be sold at 50% of book, and the market valueof 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 LiabilitiesCash 100000 Accounts payable 1000000Accounts receivable 900000 Short term secured debt 100000Other short term assets 5100000 Long term bank debt 9000000Property, plant and equipment 8000000 Shareholders equity 4000000Total 14100000 Total 14100000

Solutions

1.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

3

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%

4 a. Current Cost of Equity = 5% + 1.04*5.5% = 10.72%

Current cost of debt = (5 + 1.5) * .6 = 3.90%

Current cost of capital = 10.72% (.67) + 3.9% (.33) = 8.47%

4 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%

5.

Question 6

EBIT $ 15 Min EBIT int coverage ratio 2Interest capacity $ 8 Interest rate 11.50%

$7,901 $6,795 $274 $832 $541 $38

$503

12.50%5.53%

11.73%

$7,479

Firm Value = FCFF1/(WACC - g)

Synergy Gain = $7479 - $5879 = $1,600

A B Without synergy With Synergy

Firm Value $2,681 $3,199 $5,879

WACC 11.38%11.98% 11.73%Cost of Debt 5.53%5.53% 5.53%Cost of Equity 12.50%12.50% 12.50%

FCFF $171 $223 $394 - Δ WC $16 $22 $38 EBIT (1-t) $187 $245 $432 = EBIT $287 $378 $664 - Deprecn $74 $200 $274 - COGS $2,920 $4,043 $6,963 Revenues $3,281 $4,620 $7,901

Debt capacity $ 65

Question 7.

Estimating borrowing capacity Possible capital structureBefore After

Given: Debt 120 48 EBIT 11 MezzanineMin EBIT int coverage ratio 2 Equity 30 30 Interest capacity $ 6 Total financing 150 78 Interest rate 11.50%Debt capacity $ 48 Pre-restr debt value: 61.8

Banks might takeDebt 48 Equity 20Value 68

Question 8.Estimating borrowing capacity Preliminary capital structure

Given: Debt $ 139 EBIT $ 32 MezzanineMin EBIT int coverage ratio 2.20 Equity $ 111 Interest capacity $ 15 Total financing   $ 250 Interest rate 10.50%Debt capacity $ 139 Dividend? $ 91

Tax shield gain? 2.9PV tax shield gain? $ 39 Assumes growth 3%

WACC 10.50%

Equity value: $ 241 Shares $ 111 Dividend $ 91 Tax shield $ 39

Gain of 19%

Question 9.

Breaking Up is HardExisting Estimated Estimated

  Amtrak Amrak sans stations AmstationEBITDA $ 475.00 $ 375.00 $ 100.00 Tax rate 30% 30% 32%Beta 0.8 0.85 0.7Growth rate 3.50% 2.50% 4.5%Equity € 6,500 € 5,500 € 1,000Debt € 6,000 € 5,000 € 1,000

Risk Free 4% 4% 4%Mkt Risk Premium 5.5% 5.5% 5.5%Debt spread 2.5% 2% 4%Re 8.40% 8.68% 7.85%Rd 6.50% 6.00% 8.00%WACC 6.55% 6.54% 6.65%Enterprise PV € 16,108 € 9,505 € 4,872Equity PV € 10,108 € 4,505 € 3,872Additional Gains/losses € 1,267 € 0

Choice € 10,108  € 9,644

Question 10.

Assets Book Liquidation LiabilitiesCash 100000 100000 Accounts payable 1000000Accounts receivable 900000 720000 Short term secured debt 100000Other short term assets 5100000 2550000 Long term bank debt 9000000Property, plant and equipment 8000000 6000000 Shareholders equity 4000000Total 14100000 9370000 Total 14100000

Total available 9370000 Claim Get BalanceSecured creditors 100000 100000 9270000Bankruptcy costs 1200000 1200000 8070000Taxes 2000000 2000000 6070000Unsecured creditors 10000000 6070000

A/P 1000000 607000Banks 9000000 5463000