5/8/2012

Objectives of the Case

Corporate Finance
Survey the main consideration in the basic choice
between debt and equity financing

Calculating the impact of financing on the value of
the firm
Case Study V

Explore issues in financing the privately owned firm
Rosrio Acero S.A.
regarding voting control, decision to go public, and
the role of private-placement financing
Lecture 24
Spring 2012

Key Points Impact of financial alternatives

In 31/2 years of establishment of Rosario Acero, the firm has
Notes payable balance
undergone significant transformation
◦ Reveals that in either financing alternatives, firm’s fund
◦ The firm has weathered the strains of a divestiture, downsizing, industry requirements are satisfied – Notes payable balance
turmoil and search of new customers
◦ As recently as in 1995, the firm lost money before extraordinary items, ◦ But in adverse change of fundamental assumptions :
due to turmoil  Increased price competition

Now, it appears that the firm is on more stable footing and  Labor difficulties
can reasonably approach the capital markets for long term  Increased growth
 Rise in scrap metal price
financing.

To make a point, investors of Rosario Acero had invested ◦ Chances of lower capital requirement are slim (can be
$0.2 million to purchase the equity of the firm in July 1993, achieved through lower growth, higher productivity,
the current value of the firm is between $5.3 to $12 million restrained capex
depending upon valuation method, giving IRR of 115% and
163%

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Impact of financial alternatives Terms of notes and warrants

Interest coverage ratio and capitalization ratio
◦ Both are worst in debt financing than in equity financing
 Interest coverage ratio for the debt alternatives is very close to 2.00,
minimum acceptable coverage ratio to bondholders in 1997 and 1998.

Debt financing is associated with returns that are materially
higher than those in the case of equity.

EPS is lower by more than one half under equity financing
than under debt financing – dilution.
◦ Under equity financing, EPS does not recover to its 1996 level
during the forecast period.

Debt financing is associated with higher returns and EPS than
with equity financing, but it afford less financial flexibility and
cash flow coverage in the event of adversity.

To identify attractiveness of the terms of notes and
warrants package - find the option adjusted yield –
which is the cost to the issuer
◦ What is likely credit rating of the company
 In 1997, projected debt/capital: 75%; Interest coverage ratio:
2.03
 Probably at the lower end of the credit rating range
 As per exhibit 14, average yield of five CCC rated issues is
14.8%
 Adviser, Martinez has determined the effective cost of
comparable private placement of debt to be in range of 14% -
16%

Terms of notes and warrants Terms of notes and warrants

To compute the option adjusted yield
Volatility = 0.35 (given in case text)
◦ Value the warrants
Risk-free rate = 0.085 (case Exhibit 13)
◦ Warrant value should be applied against the principal
Maturity = 8 years (case Exhibit 5)
investment

Exercise price = $1.00 (case Exhibit 5)
◦ IRR should be computed on the cash flow
◦ Put option is ignored as the exercise price of the put is
Warrant-dilution factor = 0.853, 0.756
contingent upon future performance, which makes the ◦ If warrants are exercised for 40,000 shares, the division
valuation of the put a complex calculation. But, put option factor is 0.853; for 75,000 shares, it is 0.756.
will add more value to option than without.

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Terms of notes and warrants Terms of notes and warrants

Remaining parameters are dividend payout and today’s
Calculation of option adjusted effective cost
stock price Issue Placement Warrant Principal Total
Proceeds Costs Value Interest Payment Cash Flow
◦ Assuming no dividend payout and value of shares starting from 9 Now $7,500,000 ($52,000) ($289,679) $7,158,321
1997–1 (487,500) (487,500)
Assumed value per share $9.00 $12.00 $15.00 $18.00 $20.00 $25.00 1997–2 (487,500) (487,500)
Exercise price $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 1998–1 (487,500) (487,500)
Volatility 0.35 0.35 0.35 0.35 0.35 0.35 1998–2 (487,500) (487,500)
1999–1 (487,500) (487,500)
Term 8 8 8 8 8 8
1999–2 (487,500) (487,500)
Risk-free rate 8.5% 8.5% 8.5% 8.5% 8.5% 8.5% 2000–1 (487,500) (487,500)
Call option value (per share) $8.49 $11.49 $14.49 $17.49 $19.49 $24.49 2000–2 (487,500) (487,500)
Dilution factor 0.853 0.853 0.853 0.853 0.853 0.853 2001–1 (487,500) (487,500)
Warrant value (per share) $7.24 $9.80 $12.36 $14.92 $16.62 $20.89 2001–2 (487,500) (487,500)
2002–1 (487,500) (487,500)
Times shares granted 40,000 40,000 40,000 40,000 40,000 40,000
2002–2 (487,500) (487,500)
Total warrant value $289,679 $392,039 $494,399 $596,759 $664,999 $835,599 2003–1 (487,500) (487,500)
Option-Adjusted Effective 2003–2 (487,500) (1,875,000) (2,362,500)
cost 14.47% 14.79% 15.13% 15.47% 15.70% 16.30% 2004–1 (365,500) (365,500)
2004–2 ($365,500) ($5,625,000) ($5,990,500)
Semi-annual IRR = 6.99%
Annualized effective cost = 14.47%

Terms of Notes and Warrants Valuation of Rosario Acero’s equity

Shows that the cost of notes and warrants package
comes out to be in the range of 14.47% to 16.30%, in
line with Martinez’s estimation

If underlying shares of stock today is assumed to be $9,
the cost comes out to be 14.47% which is higher than
the 10 year government bond yield of 8.5%.
◦ But compared to cost of equity with debt, this is relatively
low cost

Pablo Este wishes that shares would float above
$9/share

Can be found from DCF valuation of free cash flow
forecast given in the case.
◦ Terminal value needs to be determined
 Assuming constant growth model with growth of 4% - 1.5%
real growth rate and 2.5% of inflation
 Making the model circular to find market value of the firm
that is consistent with the anticipated market value of
financing

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Valuation of Rosario Acero’s equity – Valuation of Rosario Acero’s equity –

Calculation of beta under debt financing
Free cash flow 1.41 1.20 1.33 1.46 1.61 1.78
AD CSA GA VAZ PI Terminal value at
perpetual growth rate = 4% 25.51
P/E Ratio 9.5 15.9 11.3 15.0 7.3 Total free cash flow $1.41 $1.20 $1.33 $1.46 $1.61 $27.29
WACC 11.3%
Beta 1.35 1.05 1.00 1.15 2.50 Value of Enterprise
($mm) $19.50
Blended cost of debt 11.75%
Unlevered Beta 0.92 0.52 0.77 0.97 1.06
After-tax cost of debt 7.76%
Asset beta 0.79
Mean Unlevered Beta 0.85
Value of debt $14.16
Value of Equity ($mm) $5.34
Market value debt/
Mean Unlevered Beta, equity 265%
without PI 0.79 Market value debt/
capital 72.6%
Levered beta 2.19
Cost of equity 20.5%
Value of Equity per
Share (fully diluted) $ 19.55

Valuation of Rosario Acero’s equity – Valuation of Rosario Acero’s equity –

under equity financing alternative method
1997 1998 1999 2000 2001 2002
Debt Equity
Free cash flow 1.41 1.20 1.33 1.46 1.61 1.78
Assumptions Financing Financing
Terminal value at
perpetual growth rate = 4% 23.52 Cash flow to equity (1997–2002) nil nil
Total free cash flow $1.41 $1.20 $1.33 $1.46 $1.61 $25.30 Terminal Values, 2002
WACC 11.9%
Value of Enterprise 1. Book value $15.09 $27.20
($mm) $17.93 2. 1.5 times book value $22.64 $40.81
Blended cost of debt 10.50%
After-tax cost of debt 6.93% 3. 4 times EBIT less debt $12.00 $24.71
Asset beta 0.79 4. 12 times earnings (exhibit12) $33.72 $44.12
Value of debt $5.90 5. 18 times earnings $50.58 $66.18
Value of Equity ($mm) $12.03
Market value debt/ 6. 21 times earnings $59.00 $77.21
equity 0.490 7. Constant growth (g = 0.03) $16.51 $33.55
Market value debt/
capital 32.9%
Levered beta 1.05
Cost of equity 14.3%
Value of Equity per
Share (fully diluted) $11.28

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Valuation of Rosario Acero’s equity – Valuation of Rosario Acero’s equity –

alternative method alternative method
Debt Equity
Financing Financing
Present Values of Total Equity
Cost of Equity
Book value $4.92 $12.21
Asset beta (average without Picasso 1.5 times book value $7.39 $18.31
Acero S.A.) 0.79 0.79
EBIT multiple (4x) $3.91 $11.09
Levered beta 2.19 1.05

Risk-free rate (exhibit 13) 8.50% 8.50% Price/ earnings (12x) $11.00 $19.80

Market risk premium 5.50% 5.50% (18x) $16.50 $29.70

Cost of equity 20.53% 14.29% (21x) $19.25 $34.65

Constant growth (g = 0.03) $5.39 $15.06

Valuation of Rosario Acero’s equity – Valuation of Rosario Acero’s equity –

alternative method alternative method

Present Values of Equity Per Debt Equity Present Values of Equity

Share Financing Financing Per Share
Assumptions: Assumptions:
New shares issued at: N.A. $9.00 New shares issued at $9.00 $12.00 $15.00 $19.00 $20.00 $25.00
Number of shares outstanding
Number of shares outstanding (million) $1.07 0.858 0.733 0.628 0.608 0.533
(millions) 0.233 1.066
Per-share estimates:
Per share estimates:
Book value $11.45 $14.23 $16.66 $19.45 $20.08 $22.91
Book value $21.13 $11.45
1.5 times book value $31.70 $17.17 1.5 times book value $17.17 $21.34 $24.98 $29.17 $30.12 $34.36
EBIT multiple (4x) $16.80 $10.40 EBIT multiple (4x) $10.40 $12.92 $15.13 $17.66 $18.24 $20.80
Price/ earnings (12x) $47.20 $18.57 Price/ earnings (12x) $18.57 $23.08 $27.01 $31.54 $32.57 $37.15
(18x) $70.80 $27.85 (18x) $27.85 $34.62 $40.52 $47.31 $48.85 $55.72
(21x) $82.60 $32.49 (21x) $32.49 $40.38 $47.27 $55.20 $56.99 $65.01
Constant growth (g = 0.03) $23.11 $14.12 Constant growth (g =
0.03) $14.12 $17.55 $20.54 $23.99 $24.77 $28.25

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Trade off between two financing Trade off between two financing
strategy strategy

Flexibility:
Risk
◦ Equity financing provide greater flexibility over debt ◦ Downturn in the economy would reduce the cash flow
financing during the strike, rise in cost, loss of revenue due from operation
to strike in major buyers like Giganto and Brasilia Metal ◦ Reduced capital spending and managed working capital and
◦ Evident in the excess cash in the firm in 2002 under the receivables can help weather the storm
heading notes payable shows, firm has excess cash $2.7 ◦ However below certain point, financing by debt is inferior
million under debt alternative compared to $7.37 under to equity
equity alternative
◦ EBIT/EPS can be good ratio to measure the impact

Trade off between two financing Trade off between two financing
strategy strategy
EBIT/EPS Relationship for 1997
$7.00
Debt Financing Alternative Equity Financing Alternative $6.00
$5.00
EBIT (1997) $1.00 $2.00 $3.00 $4.00 $1.00 $2.00 $3.00 $4.00 $4.00
$3.00
Interest $2.00
EPS

$1.00
Old $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.00
($1.00)
New $0.98 $0.98 $0.98 $0.98 $0.00 $0.00 $0.00 $0.00 ($2.00)
($3.00)
Profit before taxes ($0.72) $0.29 $1.29 $2.29 $0.26 $1.26 $2.26 $3.26 $1.00 $2.00 $3.00 $4.00
Taxes (at 0.34) ($0.24) $0.10 $0.44 $0.78 $0.09 $0.43 $0.77 $1.11 EBIT (millions)
Debt Financing Alternative Equity Financing Alternative
Net income ($0.47) $0.19 $0.85 $1.51 $0.17 $0.83 $1.49 $2.15

Within range of EBIT given in the case (3 – 6 million) debt
Number of shares dominates equity
(millions) 0.233 0.233 0.233 0.233 1.066 1.066 1.066 1.066
Point of indifference is at EBIT of $1.988mm, 42% below the
Earnings per
share ($2.03) $0.81 $3.64 $6.47 $0.16 $0.78 $1.40 $2.02
projected 1997 EBIT of $3.45

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Trade off between two financing Trade off between two financing
strategy strategy

Income (or value)
Timing
◦ Debt alternative gives higher value than by equity ◦ The Meryal Index has been rising but for company like
alternative Rosario with not so strong financial history, current

Control market might not be conducive for IPO
◦ Issue of common stock will dilute the current owners ◦ As suggested in exhibit 13, with declining interest
interest by nearly 88% rate, debt might be easy to sell.
◦ Voting control of Pablo Este will dilute from 58% to 13%
Other
◦ Under debt option, control is diluted by only 15% - 25% ◦ Este and his investment partners would like to increase
through warrants the marketability of their common shares in Rosario. An
IPO would materially meet his aim

Summary and Recommendation

Neither of two alternatives stands out as a clearly dominant
choice.

Debt is favored from the stand points of control, income, and
timing. Equity is favored from the stand point of
risk, flexibility and investment liquidity.

Choice depends upon attitude of Pable Este on these issues

Sale of the company may not be right thing as one of the
metrics used in LBO, EBIT times 4 minus total debt gives
equity value lower than equity value under debt alternatives

Another option could be use short term debt to fund
growth till more favorable capital market environment arose