BILTEK’S DILEMMA

Valuation and impact on share price based on Business and Financial Strategy

The CFO, addressing the Board of Directors of the Biltek Inc. (a debt free electronics
company) is pondering over the following exhibit which shows the ROE for the firm in
the recent years.
ROE VARIATION

25

20

15
ROE %

ROE
10

0
1998 1999 2000 2001 2002 2003 2004 2005 2006
Year

“Recent instability in the economy, a sudden surge in new products launched by our firm
and the competitors, the labour unrest followed by a strike, the scarcity of raw materials
which resulted in an increase in COGS, along with the high fixed cost proportion in our
various projects, recent entry into the foreign market, all contributed to the volatility in
the ROE.” Commented Robert, CFO of Biltek.

“But I am sure that as the growth picks up, which we are expecting in the next few
months, the operating leverage will start generating benefits for our projects and all the
investments made by us will start resulting in better returns. We may not require any
additional investments, for the next many years, as all our investments will start fetching
positive NPV, as planned, but we need to restructure the financing strategy to generate
better returns, as the market starts recovering. To that extent, we are working on a
restructuring of our existing capital structure, with the help of debt expansion and buy
back of equity.”
Below are the projected financial estimation

Projected Sales and Operating Profit

DEMAND PROB. UNITS SALES OP.Costs EBIT PAT ROE
Terrible 0.05 60,000 5,640,000 5,640,000 0 0 0
Poor 0.20 80,000 7,520,000 6,580,000 940,000 564,000 6.00%
Normal 0.50 100,000 9,400,000 7,520,000 1,880,000 1,128,000 12.00%
Good 0.20 160,000 15,040,000 10,340,000 4,700,000 2,820,000 30.00%
Excellent 0.05 200,000 18,800,000 12,220,000 6,580,000 3,948,000 42.00%

Biltek would like to reconsider the impact of capital structure on its business. They are
considering multiple options as far as Debt ratio is concerned. In fact, the company is
planning to borrow debt and repay the equity shareholders, both as an immediate reward
for the shareholders as well restructuring the capital.

The company is not planning for any additional fund raising. Biltek has currently 100,000
shares outstanding. At present, the company’s share is trading at $80, which is much
lesser than its book value.

The company is planning to repurchase the shares at $ 94/-. Biltek is trying to identify the
D/E where the firm will have optimal capital structure. The company is expecting the
cost of debt to increase for additional leverage. Biltek has a total asset base of $9,400,000
and the equity capital of the company is also $9,400,000 as currently the entire assets are
financed through equity. The company is in a tax rate of 40%.

Based on the discussion with the banks/bond holders, the average pretax cost of debt for
varying debt percentages are available below.

Debt/Assets (%) Interest Rate (%) (Pre-tax)

10 10.95%
20 11.45%
30 12.25%
40 14.05%
50 16.58%
60 20.00%

Biltek is paying entire earnings as dividends this year. Dividend is expected to grow at a
constant rate of 3%. The current risk-free rate is about 6% and the historical average risk
premium is about 4%. Biltek is currently at an unlevered beta of 1.8, although you are
almost sure that there will be a major upward change in beta with more leverage as the
investors expect a higher risk for the additional leverage.