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Case 1 for Advanced Corporate Finance: Delta Beverage Group This assignment considers the case of Delta Beverage

Group (DBG), a large bottling company. CFO Bierbaum reflects on years past in which a recapitalization plan prevented the firm from defaulting on debt. Now, rising aluminum prices are posing a threat to the firm. DBG is a franchise of PepsiCo and has no influence on retail price. Therefore, higher costs of raw material cannot be passed on to the consumer. Futures can be bought to hedge such risks, so the question is whether the CFO should engage in buying aluminum futures. First, we will calculate some key financial ratios and assess the current financial situation of Delta. Then, we make assumptions and attempt to justify them. Finally, we will project the future of the firm along multiple scenarios to come to a conclusion and give our advice to Mr. Bierbaum. Current financial situation Looking at the sales figures, we see that DBG is a large company showing little to moderate growth. And the growth is mostly enabled by the acquisitions in recent years. Furthermore, the soft drink beverages industry as a whole is clearly showing diminishing growth. Since the company is also highly leveraged, we can conclude that Delta Beverage Group is in the mature phase of the product life cycle. We can provide better insight on the companys well-being when keeping this in mind while assessing the various financial ratios. After all, ratios can vary significantly between stages of life cycle, capital-intensity, or size of the company.
Table 1: D/E ratio and Debt ratio 1989 1990 1991 165.751 162.310 164.264 69.702 57.052 35.474 223.334 210.069 203.999 2,38 2,84 4,63 0,74 0,77 0,81 1992 172.185 7.372 210.438 23,36 0,82 1993 141.149 94.268 213.705 1,50 0,66

Debt Equity Total assets D/E ratio Debt ratio

The D/E-ratio shows that the company is highly leveraged with a peak in 1992. This was the point at which the accumulated deficit reached its highest value and next year the Recapitalization Plan was performed. The ratio is in 1993 therefore much healthier according to firm characteristics (firm size, capital intensity and stage of life cycle). The debt ratio shows us how much of the firms assets are funded by debt. In this case, the ratio appears to be excessive, even after the recapitalization. As the chance of default becomes bigger, the business risk increases as well. This makes Delta Beverage Group less attractive to investors. Additionally, the bigger financial risk makes borrowing additional funds virtually impossible. DBG experienced losses at the bottom line from 1989-1993, but ameliorated during the same period. The main improvement of net income was most notably the recapitalization; the debt for equity substitution resulted in lower interest expenses.

Net income Equity (common&stockholders) ROE

Table 2: Return On Equity 1989 1990 (18.866) (17.432) 61.381 55.056 -31% -32%

1991 (14.835) 44.267 -34%

1992 (14.015) 30.382 -46%

1993 (7.877) 162.042 -5%

Furthermore, the increase in net income and equity shows a great improvement in return on equity. However, when net income becomes positive, the large amount of equity will also yield a small ROE.
Table 3: Current Ratio and Quick Ratio 1989 1990 1991 39.254 33.196 36.204 8.893 6.726 9.808 22.733 19.233 21.998 1,73 1,73 1,65 1,34 1,38 1,20 1992 41.349 10.607 27.291 1,52 1,13 1993 50.192 10.104 18.147 2,77 2,21

Current Assets Inventory Current Liabilities Current ratio Quick ratio

On a short term, there are two important parameters to consider. For both current and quick ratio, it is important for a firm to have a ratio of above 1. Both parameters show the ability to pay short-term obligations. The quick ratio omits inventory as it is not as easily convertible to cover current liabilities. Both remain throughout the whole period above 1, so do not seem to pose a threat to the firm. These ratios have to be kept in mind when implementing a strategy for future operations. We will now assess the possibility of hedging to protect the firm against rising costs. Hedging Because an operational hedge is not an option due to the fact that the production mix is linked to the market segmentation strategy, Bierbaum is looking at a financial hedge. Fructose, concentrate and other raw materials are not suitable for a financial hedge as there are no future contracts available for them. Bierbaum expects the aluminum prices to stay at the same level as in 1993 for the rest of the year 1994. Looking at both the long and short term volatility of aluminum prices (see Exhibit 10) Bierbaums expectation seems rather risky. Moreover, annual price volatility of aluminum was 30.4 percent. When considering a financial hedge on aluminum prices it is necessary to calculate Deltas exposure to Aluminum prices and furthermore, consider the risk of a breach of one the covenants of debt facilities. The most important covenant is the interest coverage ratio which should not fall below 2.0.

Without making the calculations several conclusions can be made already:

Price Aluminium 22,50% 20% 10% Future 15 M @ 22,5% Future 27M @ 22,5%

Table 4: Coverage Ratio 1993 1994 2,12x 2,23x 2,12x 2,23x 2,12x 2,23x 2,12x 2,23x 2,12x 2,23x

1995 2,04x 2,14x 2,55x 2,70x 2,60x

1996 1,77x 2,00x 2,93x 2,79x 3,44x

1) The price of a 15 or 27 months aluminum future is 7-8% higher than buying aluminum on a cash basis and assuming that the prices will remain constant. When not taking into account the macro economics (e.g. competitors, market equilibrium), we would advise Bierbaum to buy the futures if his interest coverage ratio is close to the required level of 2.0. The main argument for this conclusion is the volatile price history of aluminum, 30%. Furthermore, DBG is unable to change its product mix and it can easily be seen that the total costs of aluminum make up more than 10% of the Total Cost of Sales (roughly 40% of the cost of aluminum cans is the price of aluminum, and the sales of cans which accounts for 60% of the net Revenue). 2) It is important to have knowledge about the aluminum market. The LME is a sophisticated trading platform and over-the-counter (OTC) products are largely available. It is important to have a thorough understanding of the normal price level of aluminum. Buying futures, if there is a moderate chance of long lasting price drops, can ruin the business on the macroeconomic level. A good example is the European airline industry where most airlines had bought futures to hedge their risk on oil prices. Ryanair was one of the few who hadnt bought the futures which became one of its biggest competitive advantages. DBG needs to make a thorough assessment of the hedging behavior of its competitors. 3) The price difference between a 15 and a 27 months future is relatively low. If the risk of prices of aluminum lowering is not taken into account we would advise to buy the 27 months instead of the 15 months future. First of all we have assumed an annual price increase with 22.5%, 20% and 10%. An increase of 22.5% is based on the annual growth rate of July 93 to June 94. The increase of 20% and 10% are dummy numbers to create different scenarios (more details in appendix). We have calculated the impact of different price increases of aluminum on the interest coverage ratio and compared them with the situation if futures were bought. We can conclude that a price increase has a relative big effect on the coverage ratio. If the price increase with 22.5% than the coverage ratio will fall below the covenant ratio of 2.0 in 1996. In this case, Bierbaum must buy futures to hedge the price movements. The covenant ratio will not fall below 2.0 if the price increases below 20%. But as we can see in the table it will be more favorable to buy futures if the price increases. Bierbaum has to accept a one-off price increase of 8.7% if he buys the 27 months futures. This results in an annual increase of approximately 3%.

Conclusion Mr. Bierbaum is confronted with the dilemma of assessing the risk of rising aluminum prices. We discussed the current financial situation of the firm and conclude that although losses are made, the firm is heading in the right direction. Chances of default have decreased, but the possibility of issuing more debt remains small. If costs are going to take off, it will obviously have negative effects on net income and at some point cause a threat to the firm. Hedging is the proposed technique to shield the company from rising aluminum costs. We found that, according to our estimations, the interest coverage ratio would not fall below 2.0 before 1996 (assuming an aluminum price increase of 22.5%). Therefore, the necessity to buy futures before does not have to do with the interest coverage ratio. Our calculations along multiple scenarios do show that hedging is effectively improving future profitability if prices increase with at least 3%. Additionally, Bierbaum has to bear in mind that the aluminum market is very volatile and that sudden extra costs can be dangerous to the existence of DBG. We therefore advise him to hedge the risks by buying aluminum futures.

Appendix
1993 231.207 138.724 60.114 32.369 231.207 No Futures 1994 241.416 144.850 62.768 33.798 241.416 1995 258.363 155.018 67.174 36.171 258.363 1996 276.486 165.892 71.886 38.708 276.486

Total Revenues Sales Mix Aluminum PET Contract Sales Total Cost of Goods Sold Aluminium PET Contracts Total costs Gross Profit Selling Expenses General Expenses EBIT Depreciation & Amortization EBITDA Aluminium Tonnes
(Estimated volume growth is 4% for 1994, average volume growth 1990-1994 is 5.1%)

Based Average Growth rates

Mix 60% 26% 14%

101.269 37.271 17.479 156.018 75.189 36.791 20.561 17.837 10.894 28.731 7.938
=(8256/1,04)

105.740 38.916 18.251 162.908 78.508 39.024 22.535 16.950 12.446 29.396 8.256

113.163 41.648 19.532 174.344 84.020 41.393 24.698 17.929 11.946 29.875 8.677
=(8256*1,051)

121.101 44.570 20.902 186.573 89.913 43.905 27.069 18.939 11.500 30.440 9.120
=(8677*1,051)

GM 27% 38% 46%

Based on average growth 90-93 Based on average growth 90-94 Based on moving average

Futures Assume: scenario 1 Annual increase of Aluminium cost Cost of Goods Sold - Aluminium Gross Profit EBIT EBITDA Debt Interest Expenses Coverage Ratio

318

330

347

365

101.269 75.189 17.837 28.731 141.149 13.550 2,12x

105.740 78.508 16.950 29.396 137.149 13.166 2,23x

22,5% 117.380 79.803 13.713 25.659 131.149 12.590 2,04x

22,5% 130.300 80.714 9.740 21.241 125.149 12.014 1,77x

(1461/1193)-1 49% packing

Interest Rate 9,60%

Assume: scenario 2 Annual increase of Aluminium cost Cost of Goods Sold - Aluminium Gross Profit EBIT EBITDA Debt Interest Expenses Coverage Ratio

101.269 75.189 17.837 28.731 141.149 13.550 2,12x

105.740 78.508 16.950 29.396 137.149 13.166 2,23x

20,0% 116.103 81.080 14.990 26.935 131.149 12.590 2,14x

20,0% 127.481 83.533 12.560 24.060 125.149 12.014 2,00x

49% packing

Interest Rate 9,60%

Assume: scenario 3 Annual increase of Aluminium cost Cost of Goods Sold - Aluminium Gross Profit EBIT EBITDA Debt Interest Expenses Coverage Ratio

101.269 75.189 17.837 28.731 141.149 13.550 2,12x

105.740 78.508 16.950 29.396 137.149 13.166 2,23x

10,0% 110.921 86.261 20.171 32.117 131.149 12.590 2,55x

10,0% 116.357 94.658 23.684 35.184 125.149 12.014 2,93x

49% packing

Interest Rate 9,60%

Total Revenues Sales Mix Aluminum PET Contract Sales Total Cost of Goods Sold Aluminium PET Contracts Total costs Gross Profit Selling Expenses General Expenses EBIT Depreciation & Amortization EBITDA Aluminium Tonnes
(Estimated volume growth is 4% for 1994, average volume growth 19901994 is 5.1%)

1993 231.207 138.724 60.114 32.369 231.207

With Futures 1994 1995 241.416 258.363 144.850 62.768 33.798 241.416 155.018 67.174 36.171 258.363

1996 276.486 165.892 71.886 38.708 276.486

Based Average Growth rates

Mix 60% 26% 14%

101.269 37.271 17.479 156.018 75.189 36.791 20.561 17.837 10.894 28.731 7.938
=(8256/1,04)

105.740 38.916 18.251 162.908 78.508 39.024 22.535 16.950 12.446 29.396 8.256

113.163 41.648 19.532 174.344 84.020 41.393 24.698 17.929 11.946 29.875 8.677
=(8256*1,051)

121.101 44.570 20.902 186.573 89.913 43.905 27.069 18.939 11.500 30.440 9.120
=(8677*1,051)

GM 27% 38% 46%

Based on average growth 90-93 Based on average growth 90-94 Based on moving average

Futures

318

330

347

365

Assume: scenario 1 Annual increase of Aluminium cost Cost of Goods Sold - Aluminium 101.269 Gross Profit EBIT EBITDA Debt Interest Expenses Coverage Ratio 75.189 17.837 28.731 141.149 13.550 2,12x

105.740 78.508 16.950 29.396 137.149 13.166 2,23x

6,3% 109.003 88.180 22.089 34.035 131.149 12.590 2,70x

16,8% 118.002 93.012 22.039 33.539 125.149 12.014 2,79x

15 Months 49% packing

Interest Rate 9,60%

Assume: scenario 2 Annual increase of Aluminium cost Cost of Goods Sold - Aluminium 101.269 Gross Profit EBIT EBITDA Debt Interest Expenses Coverage Ratio 75.189 17.837 28.731 141.149 13.550 2,12x

105.740 78.508 16.950 29.396 137.149 13.166 2,23x

8,7% 110.244 86.939 20.848 32.794 131.149 12.590 2,60x

0,0% 110.244 100.770 29.796 41.297 125.149 12.014 3,44x

27 Months 49% packing

Interest Rate 9,60%