Jefferson Li

James Dong
Peter Park

Question 1:

Intel makes most of its revenues through its microprocessors and coprocessors. microcontrollers
(microprocessors and different components integrated into a single chip) made up the next
largest category of sales from Intel. At first, Intel had footed the large R&D costs, and relied on
licensing to third party manufacturers for income. However, as they were losing market share to
their own designs, in 1986 Intel stopped licensing and reserved the right to produce their new
i386 microprocessors themselves. Once this started, imitators became a large problem for Intel.
In the industry, Intel became the first movers, driving research and development for new
microprocessors, whilst imitators would copy their designs two to three years after their first
release, depending on the success of the chip.

Being a first mover had both advantages and drawbacks. By being on the cutting edge of the
semiconductor business, Intel was able to enjoy benefits like partnerships with hardware
companies that cared about being the best in the field, like IBM. IBM and Intel forged a
partnership that still exists today. These partnerships are simply impossible for imitators like
AMD who cannot offer top-of-the-line-products since they compete on prices by lowering
overall quality. Another advantage for Intel is that because they were able to dominate the
semiconductor business for so long, Intel became the microprocessor of choice for almost all
operating systems, and porting operating systems to be compatible with Intel became a common
occurrence. The main disadvantage of being the first mover in the industry was that Intel had to
pay all the R&D costs for producing new and improved CPUs, and imitators didn’t have to.
Because of this, Intel’s CPUs found it difficult to compete on prices.

To strengthen its position amongst competitors, Intel needs to secure its intellectual property
against the imitators. Intel has already been working to do so, suing imitators that have used Intel
designs to produce their own CPUs. While the other three branches of Intel’s plan to regain
market share is important, I believe that the biggest issue that Intel faces is the fact that R&D
costs for processors can exceed $500 million for each processor, and capital spending of around
$1.2 billion. On the other hand, imitators like Chips and Technologies can make an imitation for
a total of $50 million. If Intel is able to make the imitation cost extremely high, perhaps by
aggressively targeting potential intellectual property violators, then they will level the playing
field.
Question 2:

As seen in the chart above, in theory, the optimal capital structure will result in the lowest
WACC, which will maximize a firm’s value. This was done by using the levered Beta provided
in the case and unlevering it, assuming a Beta of debt = 0, as Intel was an investment-grade
bond. The debt to value ratios of different bond ratings was used as benchmarks for debt ratios
Intel could choose from. The risk-free rate was assumed to be 6.78% (the yield on a 10 year US
Treasury bond), and the risk premium assumed to be 3.48%. Using CAPM, return on assets was
calculated, as was the return on equity, for each bond rating. The return on debt was the yield as
of 1992, which was provided in the Marriott case. Then, by plugging into the WACC equation,
we can see that the lowest WACC is at 51% debt to equity.

Although empirically the lowest WACC is at 51%, the calculation does not include agency and
debt overhang problems. Also, different from conventional companies, cash is a strategic
weapon for technology companies to do further R&D or acquire start-up competitors to maintain
a competitive advantage. Technology companies are incentivized to operate at lower leverage
than the WACC calculation projects. Given the competitors are operating at around 20% debt to
capital ratio, intel should choose a capital structure between 20% to 51% to balance the optimal
capital structure and potential cash needs.

This does depend on both the yields of the types of bonds, as well as the risk-free rate of the US
Treasury bonds. For example, if the risk-free rate was to drop to 5%:

We see that the optimal WACC is now at a debt ratio of 19%. Thus, factors like changes in
interest rates of US Treasury bonds and market risk premiums will change the optimal level of
debt and make deviations acceptable, but more volatile changes in these rates could be costly as
Intel holds sub-optimal amounts of debt.

Intel, however, has a goal of keeping debt to a minimum. Intel only issues debt when the terms
are extremely favorable to them. For example, in 1983, issued $110 million of debt at under 8%
interest rate, when US-Treasury medium to long term bonds were 10.45% and 11.11%,
respectively. Instances like this make deviations from Intel’s minimal debt goal acceptable.
However, these deviations may be risky as Intel’s cash flows are historically volatile, and
increasing debt can significantly increase default risk as there is no guarantee of steady net
income. This factor also applies to the calculated “maximum debt” Intel could take, as Intel’s
volatile cash flows make such an estimate difficult to calculate.

Question 3:

From the company’s perspective, the price of the shares will be higher by share repurchase while
the price may drop by issue a dividend. One of the most important proxies for the stock price is
the P/E ratio. After issuing a buyback, the earning per share will increase as a result of fewer
shares outstanding. Assuming that the stock will trade at the same P/E multiple, the price will
increase due to the higher earnings. On the contrary, dividend payment will decrease the price of
each stock by the dividend paid per share.

Another difference to the company is that share repurchase could be used as a method to gain
from the repurchase in the future. The company often repurchases its shares when it feels the
stock price is undervalued. Therefore, the company will buy back the shares and resell it to the
market when the price goes up, and make a profit. Dividends, on the other hand, do not have the
capability to create wealth for the company after it is issued.

Since the management is often paid by stock options, a share repurchase will boost the price of
the stock, which will benefit the management. Dividends will decrease the price of each share,
thus reducing wealth for the management in the short term. Another difference to the
management as stockholders is that dividends are taxable at the moment the dividend is issued.
Stock repurchase, however, will incur an unrealized gain and the tax will be deferred into the
future.

Another difference to the management is that the management has less pressure in making
regular dividend payments with a buyback. Companies will often announce a dividend policy
rather than making repeated special dividends. As a result, companies will be pressurized in
distributing their cash flow as dividends at a given date. In contrast, stock buybacks are much
more flexible in terms of timing and how much would be returned to shareholders.
Question 4:

Under a fixed price tender offer repurchase, Intel would publicly release a tender offer to
repurchase at a fixed price a certain number of shares. Empirically, this fixed price is usually at a
premium to the contemporaneous trading price, as the company wants to provide an incentive for
shareholders to sell. This price premium would be a disadvantage. Additionally, determining the
optimal fixed price and number of shares to repurchase could be disadvantageous. An improperly
projected price could cause the firm to overpay, or for a substantial coalition of shareholders to
not accept the tender offer. Additionally, a low fixed price could cause investors to think that
management has low confidence in the company’s performance, or its upcoming earnings
release.

An advantage of fixed price tender offer repurchases is that the repurchase could be executed in a
timely fashion.

Under a Dutch auction repurchase tender offer, shareholders can establish a price range that they
will buy shares at. The firm will then pick price in this range and purchase shares from
shareholders who bid that price. A Dutch auction, compared to a fixed price tender offer, allows
a firm to gather more information about the price elasticity of its share repurchase, and possibly
identify the lowest price it can pay to repurchase its shares. Aside from gathering information
and potentially paying the lowest price, it can also identify the price at which it may repurchase
the most or desired number of shares, which may not always be the lowest price.

A Dutch auction may take longer than a fixed price tender offer, and may result in a range of
prices the company is not comfortable with. Its final choice of a price in the range might also
send a signal to the market about management’s perception of the stock’s value.

Under an open market repurchase, a firm can repurchase any amount of shares trading in the
open market at the contemporaneous price. This option is advantageous to firms as they are not
obligated to complete any announced repurchase, unlike the tender offers. While companies may
be perceived negatively if they do not go through with the planned repurchase, there are no other
negative repercussions. Management can also have flexibility over when it chooses to execute its
repurchase, as it could start its repurchase during low trading prices to realize any equity
undervaluation. This advantage of flexibility makes this open market repurchase the most used
option. The additional advantage of sending a wide signal to the market also makes it a popular
option.

In terms of disadvantages, an open market repurchase might take longer than the previous two
options and will require more planning on timing of execution.
Among these three options, a fixed price tender offer is best for Intel. While open market
repurchases offer the greatest flexibility, Sodhani admitted that gathering a consensus among
managers on a price at which Intel is undervalued would be difficult. Additionally, with the
market in recession, stock market trading would be lower and possibly not receive the news of
Intel’s repurchase as glowingly as it wished. The recession also would negatively impact the
Dutch auction. With investors generally becoming more risk-averse during a recession, they may
bid lower prices than Intel anticipates, forcing it to repurchase at a price that management does
not like. A fixed price tender offer can be wrapped up quickly and efficiently, with a high degree
of control in management’s hands.

Question 5:

Motivation:

The intention of the package of securities is to pay the investors without using the operating cash
flow. If the price drops, the warrant obligation is met by the issuance of debt. The operating cash
flow can be used in further research and development in an attempt to create more value and
boost the price in the future. If the price increases, investors are benefited by selling their
warrants to the secondary market. If the price increased beyond $75, Intel could stop paying the
bond-holders any interest at the expense of diluting its shares.

The observation that Intel is reluctant to buy back its shares in open-market operation shows that
Intel is uncertain which direction the stock price will go. If the price will drop in the future, Intel
will buy the stock expensively and its shareholders will not be benefitted. As shown in Exhibit 8,
the estimated high price in 1991 is $59, while the estimated low price is $37. The motivation to
sell put-warrants is to secure the price at which Intel will buy back the shares. Investors, on the
other hand, could immediately sell-off the warrants and pocket sixty cents per share, or $125.4
million, risk-free and not at Intel’s expense. If the price in two years drops below $50 and Intel is
obligated to pay $1 billion, the payment could be made up by the $1 billion convertible debt that
Intel has issued. If the price goes beyond $50, the warrants will not be exercised and Intel has no
obligation to pay. In the meantime, Intel’s investors have pocketed $125.4 million from the
secondary market.

Effect on the Capital Structure:

On 1990, the net debt/total asset is around -27%. On 1991 if Intel were to undertake this
initiative, the cash balance will increase to $3277 million by issuing $1 billion convertible debt.
Accordingly, the long-term debt will increase from $345 million in 1990 to $1,363 million in
1991. As shown in figure 2, although Intel has to pay 5% coupon rate as an interest to the
bondholders, Intel is able to make well over 5% as interest income on its pile of cash. Therefore,
it is expected that Intel can pay off the cost of the debt with the debt’s interest income.

Two years after the decision is made, if the stock price is under $50, Intel has the obligation to
pay $1 billion to the warrant holders; thus reducing the cash balance to $2277 million. However,
Intel still has the convertible bond on its balance sheet. The total asset will reduce to $6292
million due to the cash pay-out. The new net debt to total assets will increase to -15%. Since
Intel will have to repurchase 20.9 million shares, the share count reduces to 188.09 shares.

If the stock price is between $50 and $75, the warrants will not be exercised. Therefore, the cash
balance remains at $3277 million with $1363 million of long-term debt. The total asset and
number of shares will remain at $7292 million and 208.99 million.

If the stock price is beyond $75, the convertible bond will be converted. The cash balance
remains at $3277 million while its long-term debt will reduce to $363 million. The total asset
will remain at $7292. With the new issuance of equity to the convertible bondholders, the
number of shares will increase to 222.29 million.

Figure 1

Figure 2

Question 6​:

The ideal cash disbursement mechanism is a tender offer repurchase at a fixed price. Intel’s
competitive positioning and dynamics require it to hold a large amount of cash reserves, so it can
deploy it to pursue regularly scheduled R&D projects, as well as any opportunistic projects, that
enable it to stay ahead of the curve and innovate ahead of copycats and competitors. Intel
management’s parsimonious usage of debt also makes its large cash reserves its primary way of
funding its capital expenditures. Due to the fact that Intel needs large cash reserves, any
recurring cash outflow, such as a dividend, would not be optimal for the firm. Additionally, Intel
earns an above-average return on its cash reserves, which provides another incentive for it to not
disburse dividends.

Ruling out dividends, the choices can be narrowed down to a form of share repurchase and the
2-year put-warrants. Given the contemporaneous market conditions of a recession and by
association, a more conservative/muted stock market, it can say that a share repurchase is
marginally better than the put-warrants. Firstly, the put-warrants are two unconventional
products in one. With less visibility and understanding of these products comes less trading
volume of the products, which would only get worse during a recession. A low trading volume of
these put-warrants would not price them efficiently, or to Intel’s liking.

Share repurchases, as one-off cash disbursements that send a positive signal to the market and
enrich shareholders, are the recommended form of cash disbursement for Intel. Intel can control
how much cash it disburses in the share repurchase, and can control its flexibility and control
over its execution with the 3 aforementioned options. Intel also has a history of preferring these
one-off financial transactions as opposed to recurring transactions. Its careful selection of the
timing and structure of its debt issuances lend credence to the notion that management would
prefer a share repurchase. Finally, given that the fixed price tender offer repurchase was the best
structure among the three, this structure and cash disbursement mechanism is recommended for
Intel.