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 0.499999D 14.00%
0.5 0.799999C 12.70%
0.8 1.249999CC 11.50%
1.25 1.499999CCC 10.00%
 1.5 1.999999B- 8.00%
2 2.499999B 6.50%
2.5 2.999999B+ 4.75%
3 3.499999BB 3.50%
3.5 4.499999BBB 2.25%
4.5 5.999999A- 2.00%
6 7.499999A 1.80%
7.5 9.499999A+ 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 11m

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 120m paying 8.5% 10.2
Equity is estimated to be worth 30m 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.

A B Without synergy With Synergy

Revenues $4,620 $3,281 $7,901 $7,901
- COGS $4,043 $2,920 $6,963 $6,795
- Deprecn $200 $74 $274 $274
= EBIT $378 $287 $664 $832
EBIT (1-t) $245 $187 $432 $541
- Δ WC $22 $16 $38 $38
FCFF $223 $171 $394 $503

Cost of Equity 12.50% 12.50% 12.50% 12.50%

Cost of Debt 5.53% 5.53% 5.53% 5.53%
WACC 11.98% 11.38% 11.73% 11.73%

Firm Value $3,199 $2,681 $5,879 $7,479

Firm Value = FCFF1/(WACC - g)

Synergy Gain = $7479 - $5879 = $1,600

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 takeDebt 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

Cash 100000 100000 Accounts payable 1000000
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 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