Case

10

Aspeon

Sparkling

Water,

Inc.

Capital
CASE INFORMATION

Structure

Policy

Purpose
This case, which in all aspects is identical to Case 9, illustrates the capital structure decision for a firm that starts with zero debt. Either Case 9 or Case 10, but not both, should be assigned. The primary analytical tool is valuation analysis, although the case briefly introduces the Modigliani and Miller (MM) with corporate taxes and Miller models. The case also illustrates financial risk by looking at the impact of leverage on ROE.

Time Required
The case requires 3-4 hours of preparation, plus an additional hour if the case has to be handed in.

Complexity
B--intermediate complexity.

Flexibility
The case illustrates many of the concepts associated with the use of debt financing, and hence provides an ideal vehicle for summarizing that section of the course.

MODEL

INFORMATION

Description
The case model (filename CASE-10I) has two major sections. The first section constructs partial income statements to illustrate

1993 Case 10-1

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the effect of financial leverage on ROE, while the second part conducts the valuation analysis, where stock price, EPS, and WACC are calculated on the basis of capital cost relationships. The INPUT DATA and KEY OUTPUT sections are shown below:

INPUT DATA:

KEY OUTPUT:

Operating Data:

Impact on ROE:

Total assets $120,000,000 Cost of debt EBIT Tax rate No. of shares 13.0% $32,000,000 40% 10,000,000

All equity: Expected ROE SD of ROE 16.0% 7.8%

50/50 mix: Expected ROE 24.2% 15.6%

Capital Cost Data:

SD of ROE

D ----------$0 25,000,000 50,000,000 75,000,000 100,000,000 125,000,000

kd ------0 10.0% 11.0% 13.0% 16.0% 20.0%

Valuation Analysis:

D ----------$0 25,000,000 50,000,000 75,000,000 100,000,000

P ------$12.00 13.23 14.09 14.53 14.57 14.12

D ----------$0 25,000,000 50,000,000 75,000,000 100,000,000 125,000,000

ks ------16.0% 16.5% 17.5% 19.0% 21.0% 26.0%

125,000,000

Model Use
The model can be used to gain insights into the capital structure decision. For this purpose, we assign the Lotus parts of question 7.

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CASE

SOLUTION

Note: Our answers were calculated using the Lotus model. Students' answers obtained with a calculator may vary from those given here because of rounding errors.

Summary of Numerical Answers

2.
(Dollars in Thousands) All Equity 50% Debt ___________________________ ___________________________ $10,000 $32,000 $54,000 $10,000 $32,000 $54,000 6,000 5.0% n.a. 19,200 16.0% n.a. 16.0% 7.8% .49 32,400 27.0% n.a. 1,320 2.2% 1.28 14,520 24.2% 4.10 24.2% 15.6% .64 27,720 46.2% 6.92

EBIT a. b. Net income ROE TIE

c.

E(ROE) Std dev (ROE) CV

4. $

D 0 25,000,000 50,000,000 75,000,000 100,000,000 125,000,000

a.

Price $12.00 13.23 14.09 14.53 14.57 14.12

b.

# Shares 10,000,000 8,109,966 6,450,304 4,836,957 3,137,255 1,144,414

c. 5. a.

Optimal debt ratio = 69%. S V P n1 S V P n1 D = = = = = = = = $44,594,595. $69,594,595. $7.05. 6,323,312. $45,000,000. $69,038,462. $7.10. 6,335,193. a. EPS $1.02 1.15 1.29 1.43 1.58 1.88 c. WACC 17.0% 15.5 14.7 14.2 14.2 14.6

b.

6. $

0 12,500,000 25,000,000 37,500,000 50,000,000 62,500,000 VL = $75,000,000.

8.

a.

b.

VL = $73,392,857.

Question 1
a. Business risk is the risk faced by a firm's stockholders if the firm uses no financial leverage. It can be thought of as the inherent riskiness of the firm's assets. Financial risk is the additional risk borne by stockholders as a result of the use of debt financing. Business risk depends on a number of factors, including competition, liability exposure, and operating leverage. Financial risk depends on the amount of fixed charge (debt and preferred stock) financing. In the total risk sense, one common measure of business and financial risk is the variability of ROE, often expressed as the standard deviation, _. An otherwise identical but unlevered firm would have a smaller _ROE than a levered firm. The difference is a measure of financial risk: Total risk = _ROE. Business risk = _ROE(Unlevered). Financial risk = _ROE _ROE(Unlevered). c. Robert Hamada combined the CAPM and the MM with corporate taxes model (MM63). The result provides some insights into business and financial risk within a market risk framework. He obtained this expression for the cost of equity: ks = kRF + (kM kRF)bU + (kM kRF)bU(1 T)(D/S). Here we see that investors require a return to compensate them for the time value of money, kRF; a premium to compensate them for business risk, (kM kRF)bU; and a premium to compensate them for bearing financial risk, (kM kRF)bU(1 T)(D/S). Hamada also developed this equation to show how leverage affects beta: bL = bU + bU(1 T)(D/S). An unlevered firm's beta depends solely on the firm's business risk, but the use of financial leverage causes the firm's beta to increase. Thus, within a market risk framework: Total market risk = bL. Business market risk = bU.

b.

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Financial market risk = bL bU. d. Business risk is the single most important determinant of a firm's capital structure. The greater the risk inherent in a firm's assets, then, at any debt level, the greater the probability of financial distress for the firm. Also, the greater the business risk, the greater kd and ks would be for the firm as the firm's debt ratio increases. Thus, high (low) business risk results in an optimum capital structure with a low (high) debt ratio.

Question 2
a. and b. Partial income statements and key ratios for Aspeon at zero debt and 50 percent debt, along with the key ratios, are shown below. Note that Aspeon now has 10 million shares outstanding at a price of $12, so the value of the equity is $120 million.

All Equity -----------------------------------Probability EBIT Interest 0.25 $10,000,000 0 ----------EBT Taxes $10,000,000 4,000,000 ----------Net Income $6,000,000 =========== ROE TIE E(ROE) Std dev ROE CV 5.0% n.a. 0.50 $32,000,000 0 ----------$32,000,000 12,800,000 ----------$19,200,000 =========== 16.0% n.a. 16.0% 7.8% 0.49 0.25 $54,000,000 0 ----------$54,000,000 21,600,000 ----------$32,400,000 =========== 27.0% n.a.

50% Debt -----------------------------------Probability EBIT Interest 0.25 $10,000,000 7,800,000 ----------EBT Taxes $2,200,000 880,000 ----------Net Income $1,320,000 =========== ROE TIE E(ROE) Std dev ROE CV 2.2% 1.28 0.50 $32,000,000 7,800,000 ----------$24,200,000 9,680,000 ----------$14,520,000 =========== 24.2% 4.10 24.2% 15.6% 0.64 0.25 $54,000,000 7,800,000 ----------$46,200,000 18,480,000 ----------$27,720,000 =========== 46.2% 6.92

c.

If Aspeon uses all-equity financing, its expected ROE is 16.0 percent and _ROE is 7.8 percent. When half debt financing is used, expected ROE increases to 24.2 percent. However, this leveraging up of expected return is not without costs--the standard deviation has doubled to 15.6 percent. The coefficient of variation (CV) increases from 0.49 to 0.64, or by 31 percent. Thus, the use of financial leverage has both benefits and costs. Note that debt financing only increases ROE if the cost of debt is less than the basic return on the assets, or basic earning power. At $10,000,000 of EBIT, the basic return on the assets is EBIT/TA = $10,000,000/$120,000,000 = 8.33%. With debt costing 13 percent, ROE is decreased by the use of financial leverage, from 5.0 to 2.2 percent. However, at $32,000,000 of EBIT, the basic return on assets is 27 percent,

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and hence leveraging with debt which costs increases the ROE from 16.0 to 24.2 percent.

13

percent

Question 3
a. Begin by noting that (EBIT kdD) = EBT and that (EBIT kdD) (1 T) = Net Income. Since Aspeon is not expected to grow, all earnings must be paid out as dividends, and hence Net income = Dividends. With zero growth, the dividend stream represents a perpetuity which is valued by dividing the constant dividend payment by the required rate of return on equity. Thus, Equation (1) is the value of the equity of a zero-growth firm. Aspeon must first announce its recapitalization plans. Then investors would reassess their views concerning the firm's profitability and risk, and then estimate a new value for the equity. No current shareholder would be willing to sell at a price below the expected post-capitalization price, so the market price would quickly adjust to a new equilibrium that reflects the recapitalization, even though it has not yet taken place. Finally, Aspeon would issue the debt and use the proceeds to repurchase stock at the new equilibrium price. The firm would end up with more debt but fewer common shares.

b.

Question 4
a. and b. Here's the analysis for $25,000,000 of debt: (1) (2) S = ($32 0.10(25.0))(0.6)/0.165 = $107,272,727. V = $107,272,727 + $25,000,000 = $132,272,727.

(3)

P = ($132,272,727 $0)/10,000,000 = $13.23.

(4) n1 = 10,000,000 ($25,000,000/$13.23) = 8,109,966. The following table completes the analysis:
D $0 $25,000,000 $50,000,000 $75,000,000 $100,000,000 $125,000,000 S $120,000,000 107,272,727 90,857,143 70,263,158 45,714,286 16,153,846 V 120,000,000 132,272,727 140,857,143 145,263,158 145,714,286 141,153,846 D/V 0% 19% 35% 52% 69% 89%

D $ 0 25,000,000 50,000,000 75,000,000 100,000,000 125,000,000

P $12.00 13.23 14.09 14.53 14.57 14.12

WACC 16.0% 14.5% 13.6% 13.2% 13.2% 13.6%

# Shares 10,000,000 8,109,966 6,450,304 4,836,957 3,137,255 1,144,414

EPS $1.92 2.18 2.47 2.76 3.06 3.67

c.

A capital structure with $100,000,000 of debt maximizes the firm's stock price at $14.57, and hence is the best structure of those considered. Some students might argue that we now have to worry about the increased riskiness caused by using debt financing, but this argument is incorrect--the new stock prices already reflect the higher risk because kd and ks have been adjusted to reflect financial risk.

Question 5
a. This situation is basically the same as before, except that the firm starts with some debt outstanding: (1) (2) (3) S = ($32 0.11($50))(0.6)/0.175 = $90,857,143. V = $90,857,143 + $50,000,000 = $140,857,143. P = ($140,857,143 $25,000,000)/8,109,966 = $14.29.

(4) n1 = 8,109,966 ($25,000,000/$14.29) = 6,360,491. 1993 The

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Case 10-9

Note that the calculations can be checked easily--the new number of shares divided into the new equity value must produce the new stock price: $90,857,143/6,360,491 = $14.29. Also note the difference in the results. In this scenario the stock price is higher and the remaining number of shares lower than when the firm moves directly from zero debt to $50 million of debt. b. In this scenario, Aspeon ends up with two different debt issues outstanding, the initial $25.0 million issue with a 10 percent coupon and a new $25.0 million issue with a 11 percent coupon. Note, however, that the required rate of return on all debt is now 11 percent, so the old issue loses value in this situation. (1) S = ($32 0.11($25.0) 0.10($25.0))(0.6)/0.175 = $91,714,286. V = $91,714,286 + $25,000,000 + 0.10($25,000,000)/0.11 = $116,714,286 + $22,727,272 = $139,441,558. P = ($139,441,558 $22,727,272)/8,109,966 = $14.39.

(2)

(3)

(4) n1 = 8,109,966 ($25,000,000/$14.39) = 6,372,648. c. The price is higher in Scenario 2 (Question 5.a.) than in Scenario 1 (Question 4) because $50,000,000 in shares were repurchased at $14.09 per share in Scenario 1, while $25,000,000 were repurchased at $13.23 per share in Scenario 2. By moving to $50,000,000 of debt in steps, the firm repurchases stock at a lower average price, and hence there are more shares repurchased and fewer left outstanding at the end. In Scenario 3 (Question 5.b.), in addition to the point just made, some of the value lost by the old bondholders is "captured" by the shareholders, and this produces an even higher final price. Of course, both of these actions are unethical and we would not suggest that they be used. Besides, such actions would undoubtedly result in lawsuits and bad feelings that would ultimately be detrimental to the remaining shareholders.

Question 6
a. Refer to the data presented in the answer to Question 4. To illustrate the EPS calculation, consider the $25.0 million debt level: (1) NI = ($32 0.10(25.0))(0.6) = $17,700,000.

(2)

EPS = $17,700,000/8,109,966 = $2.18.

Here are the data for all debt levels:

D $ 0 25,000,000 50,000,000 75,000,000 100,000,000 125,000,000 P $12.00 13.23 14.09 14.53 14.57 14.12 WACC 16.0% 14.5% 13.6% 13.2% 13.2% 13.6% # Shares 10,000,000 8,109,966 6,450,304 4,836,957 3,137,255 1,444,414 EPS $1.92 2.18 2.47 2.76 3.06 3.67

A SPEON SPARKLING W ATER, INC.

$15 $14 $13 $12 $11 $10 $9 Price and EPS $8 $7 $6 $5 $4 $3 $2 $1 $0 $25 ,00 0 $50 ,000 D ollars of D ebt (0 00s) S tock Price EP S $ 75,000 $10 0,0 00 $ 125,00 0 Debt versus P rice and EPS

b.

EPS continues to rise throughout the range of debt levels selected, while stock price is maximized at $100 million of debt (see Figure 1). Eventually, EPS would also peak and then fall. EPS is not a good guide to a firm's optimal capital structure because it does not fully reflect the impact of financial leverage on stockholder risk. (EPS does not capture the increase in the cost of equity as more and more debt financing is used.) The WACC is calculated by applying the market value weights to 1993 The Dryden Press
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c.

Case 10-11

the component costs. For example, at $25.0 million of debt, the WACC is 14.5 percent: WACC ($107.273/$132.273)(16.5%) = 14.5%. See the table on page 10-8 for the WACCs at different levels of debt. d. The WACC is minimized at that debt level which maximizes stock price. This should be intuitive because the value of the firm is simply the present value of its future cash flows, and the lower the discount rate, the higher the present value. = ($25.0/$132.273)(10.0%)(0.6) +

Question 7
a. If the firm had higher business risk, then, at any debt level, its probability of financial distress would be higher and the firm would be riskier. Investors would recognize this, and both kd and ks would be higher at each debt level than originally estimated. The result would be an optimal capital structure with less debt. In this situation, with higher business risk and hence faster growth in capital costs as more and more debt is used, the stock price is maximized at $12.72 per share when $75,000,000 of debt is employed.
D (000s) S V 112,941,176 122,500,000 126,500,000 127,173,913 126,666,667 126,406,250 D/V 0% 20 40 59 79 99 P $11.29 12.25 12.65 12.72 12.67 12.64 WACC # Shares EPS $1.92 2.21 2.53 2.93 3.42 4.05

$0 $112,941,176 $25,000 $50,000 $75,000 $100,000 $125,000 97,500,000 76,500,000 52,173,913 26,666,667 1,406,250

17.0% 10,000,000 15.7 15.2 15.1 15.2 15.2 7,959,184 6,047,431 4,102,564 2,105,263 111,248

b.

Conversely, lower business risk would lead to lower capital costs at each debt level and an optimal structure that used more debt. In this situation, with lower business risk and hence slower growth in capital costs as more and more debt is used, the firm's optimal capital structure would call for $125,000,000 of debt (on the basis of the debt levels given in the case). The stock price would be $17.28 per share.
D(000s) $ 0 25,000 50,000 75,000 100,000 125,000 S $137,142,857 125,874,126 111,000,000 93,281,250 70,285,714 47,763,158 V $137,142,857 150,874,126 161,000,000 168,281,250 170,285,714 172,763,158 D/V 0% 17 31 45 59 72 P $13.71 15.09 16.10 16.83 17.03 17.28 WACC 14.0% 12.7 11.9 11.4 11.3 11.1 # Shares 10,000,000 8,342,990 6,894,410 5,543,175 4,127,517 2,764,661 EPS $1.92 2.16 2.41 2.69 2.98 3.28

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Question 8
a. VL = = = = VL = = = = = = VU + TD $120,000,000 + 0.4($75,000,000) $120,000,000 + $30,000,000 $150,000,000. VU + [1 (1 $120,000,000 + $120,000,000 + $120,000,000 + $120,000,000 + $146,775,000. Tc)(1 Ts)/(1 Td)]D [1 (0.60)(0.75)/(0.70)]D [1 0.643]D 0.357($75,000,000) 26,775,000

b.

c.

The answers differ because the assumptions are different. MM63 assumes that only corporate taxes exist while Miller assumes that both corporate and personal taxes are present. However, neither capital structure theory model includes any of the costs associated with debt financing (financial distress costs, agency costs, and so on). The valuation analysis does include these costs, and hence this model results in the lowest value for the firm.

Question 9
Control would clearly be an issue. There is a danger of loss of control if the company does not use enough debt (through a leveraged buyout), but there is also a danger of loss of control (through bankruptcy) if it uses too much debt. In our classes, we generally have an animated discussion on this point, but it is impossible to reach a conclusion as to how control should affect the decision.

Question 10
a. The analysis used in this case requires the assumption of zero growth and perpetual debt, and most "real world" firms do not meet these assumptions. Although there are similar, but more complicated, equations that could be used for growth firms, most managers do not use valuation models to set their capital structures. Most managers use financial forecasting models to assess capital structure changes. Here alternative structures are assumed and the impact of the alternatives on the firm's future financial condition are noted. Forecasting models can easily generate the output associated with various scenarios, but it remains up to the financial manager to assign input values, interpret the output, and finally set the target structure. The target capital structure is best thought of as a range for two reasons. First, there is no precise way to estimate the optimal capital structure, so it would be inappropriate to specify a point value. Second, a firm's actual capital structure is going to vary over time as stock and bond prices react to market conditions and as the firm issues new securities. Thus, most firms specify their target structures as a range, say, 40 to 45 percent debt, and then, over time, take actions to keep the firm's structure in the target range.

b.

c.

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d.

Since it is very difficult to quantify the capital structure decision, managers usually consider the following factors along with the results from the forecasting model: (1) (2) (3) (4) (5) (6) (7) Average debt usage for the industry. Pro forma TIE ratios under different scenarios. Lender/rating agency attitudes. Reserve borrowing capacity. Effects of capital structure changes on control. Type of assets. Expected tax rate.