1 - NYU



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 B

Revenues $4,620 $3,125

Cost of Goods Sold (w/o Depreciation) 87.50% 89.00%

Depreciation $200.00 $74.00

Tax Rate 35.00% 35.00%

Working Capital 10% of Revenue 10% of Revenue

Market Value of Equity $2,000 $1,300

Outstanding 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 firms | | |

|If interest coverage ratio is | | |

|> |≤ |Rating is |Spread is | |

|-100000 |0.499999 |D |14.00% | |

|0.5 |0.799999 |C |12.70% | |

|0.8 |1.249999 |CC |11.50% | |

|1.25 |1.499999 |CCC |10.00% | |

|1.5 |1.999999 |B- |8.00% | |

|2 |2.499999 |B |6.50% | |

|2.5 |2.999999 |B+ |4.75% | |

|3 |3.499999 |BB |3.50% | |

|3.5 |4.499999 |BBB |2.25% | |

|4.5 |5.999999 |A- |2.00% | |

|6 |7.499999 |A |1.80% | |

|7.5 |9.499999 |A+ |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 |11 |m |

|Discussions with the banks show that in order to extend credit, they insist on | |

|a minimum EBIT interest coverage ratio of |2 | | | | |

|Currently US treasurys pay | |5% | | | |Cost |

|The company now has debt of | |120 |m |paying |8.5% |10.2 |

|Equity is estimated to be worth |30 |m | | |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? | | |

8.

|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? | |

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 |Amstation |

|EBITDA | $ 475.00 | $ 375.00 | $ 100.00 |

|Tax rate |30% |30% |32% |

|Beta |0.8 |0.85 |0.7 |

|Growth rate |3.50% |2.50% |4.5% |

|Equity |€ 6,500 |€ 5,500 |€ 1,000 |

|Debt |€ 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% |

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 | |Liabilities | |

|Cash |100000 |Accounts payable |1000000 |

|Accounts receivable |900000 |Short term secured debt |100000 |

|Other short term assets |5100000 |Long term bank debt |9000000 |

|Property, plant and equipment |8000000 |Shareholders equity |4000000 |

|Total |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 |2 |

|Interest capacity | | $ 8 |

|Interest rate | |11.50% |

|Debt capacity | | $ 65 |

Question 7.

|Estimating borrowing capacity | |Possible capital structure | |

| | | | | | | |Before |After |

|Given: | | | | |Debt | |120 | 48 |

|EBIT | | |11 | |Mezzanine | | |

|Min 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 take |Debt | 48 |

| | | | | | | |Equity |20 |

| | | | | | | |Value |68 |

Question 8

.

|Estimating borrowing capacity | |Preliminary capital structure | |

| | | | | | | | | |

|Given: | | | | |Debt | | | $ 139 |

|EBIT | | | $ 32 | |Mezzanine | | |

|Min 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? | |2.9 |

| | | | | |PV 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 Hard | | | |

| |Existing |Estimated |Estimated |

|  |Amtrak |Amrak sans stations |Amstation |

|EBITDA | $ 475.00 | $ 375.00 | $ 100.00 |

|Tax rate |30% |30% |32% |

|Beta |0.8 |0.85 |0.7 |

|Growth rate |3.50% |2.50% |4.5% |

|Equity |€ 6,500 |€ 5,500 |€ 1,000 |

|Debt |€ 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 |€ 4,872 |

|Equity PV |€ 10,108 |€ 4,505 |€ 3,872 |

|Additional Gains/losses | |€ 1,267 |€ 0 |

| | | | |

|Choice |€ 10,108 |  |€ 9,644 |

Question 10.

|Assets | | |Book |Liquidation |Liabilities |

|Other short term assets |5100000 |2550000 |Long term bank debt | |9000000 |

|Property, plant and equipment |8000000 |6000000 |Shareholders equity | |4000000 |

Total | | |14100000 |9370000 |Total | | |14100000 | | | | | | | | | | | |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 | | | | | |

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