Corporate Financial Restructuring Sample Questions with suggested answers

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 cos

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

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%

Interest Expenses $ 120

EBIT Int Coverage Ratio 8.33

Bond Rating AA

After-tax Cost of Debt 4.80%

The interest coverage ratios, ratings and spreads are as follows:

Coverage Ratio Rating Spread over Treasury

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.

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

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

0.8 1.249999CC 11.50%

1.25 1.499999CCC 10.00%

1.5 1.999999B- 8.00%

3.5 4.499999BBB 2.25%

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 11m

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

a minimum EBIT interest coverage ratio of 2

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

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:

Amtrak Amrak sans stations Amstation EBITDA $ 475.00 $ 375.00 $ 100.00

Beta 0.8 0.85 0.7

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?

Property, plant and equipment 8000000 Shareholders equity 4000000

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

( spread changes, so recalculate Interest until rating remains constant)

After-tax Cost of Debt 4.80%

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

Min EBIT int coverage ratio 2

Interest capacity $ 8

$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

Debt capacity $ 65

Question 7.

Before After

Interest capacity $ 6 Total financing 150 78

Banks might takeDebt 48

Question 8

.

PV tax shield gain? $ 39

Equity value: $ 241

Shares $ 111 Dividend $ 91 Tax shield $ 39

Question 9.

Breaking Up is Hard

Amtrak Amrak sans stations Amstation EBITDA $ 475.00 $ 375.00 $ 100.00

Risk Free 4% 4% 4%

Question 10.

Accounts receivable 900000 720000 Short term secured debt 100000 Other short term assets 5100000 2550000 Long term bank debt 9000000 Property, plant and equipment 8000000 6000000 Shareholders equity 4000000

Total available 9370000 Claim Get Balance

Secured creditors 100000 100000 9270000

Bankruptcy costs 1200000 1200000 8070000

Unsecured creditors 10000000 6070000

Banks 9000000 5463000