Restructuring Debt and Equity - Problems and Solutions

You have been asked to evaluate

whether a company has an appropriate amount of debt.

Debt outstanding: 1,000 EUR million

Debt rating: AAA
Market rate on bonds with rating AAA 5.10%
Government 10-year bond rate: 4.25%
Estimated pretax profit 1600
Based on the company's interest coverage prepare a table
showing what an increase in long term debt would do to the company's ratings and its cost of borrowing
Interest Debt /
New Interest Interest coverag capitalizat
New debt Total debt Rating rate expense e ratio ion
0 1,000 AAA 5.10% 51 32.37 3%
2500 3,500 AA 5.10% 179 9.96 11%
5000 6,000 A+ 5.67% 340 5.70 19%
10000 11,000 A- 6.01% 661 3.42 35%

Corporate bond spreads: basis points over Treasury curve Typical Interest Coverage Ratios
Rating 1year 2year 3year 5year 7year 10year 30year
Aaa/AAA 40 45 50 60 74 85 96 >8.50
Aa1/AA+ 45 55 60 70 84 95 106 6.50-8.50
Aa2/AA 55 60 65 75 89 105 116 6.50-8.50
Aa3/AA- 60 65 70 85 99 117 136 6.50-8.50
A1/A+ 70 80 90 105 119 142 159 5.50-6.50
A2/A 80 90 105 120 140 157 179 4.25-5.50
A3/A- 90 100 110 130 150 176 196 3.00-4.25
Baa1/BBB 105 115 128 145 165 186 208 2.50-3.00
Baa2/BBB 120 130 140 160 180 201 221 2.50-3.00
Baa3/BBB- 140 145 155 172 193 210 232 2.50-3.00
Ba1/BB+ 225 250 275 300 325 350 440 2.00-2.50
Ba2/BB 250 275 300 325 350 385 540 2.00-2.50
Ba3/BB- 300 350 375 425 445 460 665 2.00-2.50
B1/B+ 375 400 425 500 550 610 765 1.75-2.00
B2/B 450 500 550 625 670 710 890 1.50-1.75
B3/B- 500 550 650 750 875 975 1075 1.25-1.50
Caa/CCC 600 650 800 900 1025 1150 1300 0.80-1.25
A company is struggling with a weaker market. It expects a turnaround in a couple of years,
but now must work out the amount of debt it can carry.

Based on last year's performance, management estimates EBIT at 12 m

Discussions with the banks show that in order to avoid violating covenants
a minimum EBIT interest coverage ratio of 1.3 must be maintained
Currently US treasurys pay 4%
It currently has debt of 90 m
What is the company's debt capacity?

Estimating borrowing capacity

EBIT/Cov. ratio
Given:
EBIT $ 12
From table
Min EBIT int coverage ratio 1.3
Interest capacity $ 9
Int Cap./rate
Interest rate 14.00%
Debt capacity $ 66

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%
9.5 12.5 AA 1.00%
12.5 100000 AAA 0.75%
A company is struggling 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 1.5
Currently US treasurys pay 4% Cost
The company has debt of 110 m paying 12.0% 13.2
Equity is estimated to be worth 30 m Coverage ratio:
What is the debt worth? 0.8
What is the company's debt capacity?
What new capital structure could be negotiated with the banks?

Estimating borrowing capacity Possible capital structure

Before After
Given: Debt 110 61
EBIT 11 Mezzanine
Min EBIT int coverage ratio 1.5 Equity 30 30
Interest capacity $ 7 Total financing 140 91
Interest rate 12.00%
Debt capacity $ 61 Pre-restr debt value: 79.0
Banks happy with Debt 61
Equity 20
Value 81
For smaller and riskier firms
If EBIT 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%
9.5 12.5 AA 1.00%
12.5 100000 AAA 0.75%
The company has succeeded in improving EBIT
Now management is considering doing a leveraged recap

Currenty the company has debt of 90 m

Management estimates EBIT at 45 m
Banks' minimum EBIT interest coverage ratio 2
Currently US treasurys pay 4%
The estimated value of the firm is 250 m
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?

Estimating borrowing capacity Preliminary capital structure

Given: Debt $ 214

EBIT $ 45 Mezzanine
Min EBIT int coverage ratio $ 2 Equity $ 36
Interest capacity $ 23 Total financing $ 250
Interest rate 10.50%
Debt capacity $ 214 Dividend? $ 124
Tax shield gain? 3.9
PV tax shield gain? $ 54
Assumes growth 3%
WACC 10.50%

Equity value: $ 214

Shares $ 36
Dividend $ 124
Tax shield $ 54
For smaller and riskier firms Gain of 34%
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%
9.5 12.5 AA 1.00%
12.5 100000 AAA 0.75%