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%

$ Debt

$ 1,500

EBIT

$ 1,000

Interest Expenses

$ 120

EBIT Int. Coverage Ratio

8.33

20%

Extra Column

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 firms 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.
Revenues
Cost of Goods Sold (w/o Depreciation)
Depreciation
Tax Rate
Working Capital
Market Value of Equity
Outstanding Debt

A
$4,620
87.50%
$200.00
35.00%
10% of Revenue
$2,000
$160

B
$3,125
89.00%
$74.00
35.00%
10% of Revenue
$1,300
$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
2
2.5
3
3.5
4.5
6
7.5

1.999999B2.499999B
2.999999B+
3.499999BB
4.499999BBB
5.999999A7.499999A
9.499999A+

8.00%
6.50%
4.75%
3.50%
2.25%
2.00%
1.80%
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:

EBITDA
Tax rate

Existing
Estimated
Amtrak Amrak sans stations
475.00 $
375.00 $
30%
30%

Estimated
Amstation
100.00
32%

Beta
Growth rate
Equity
Debt
Risk Free
Mkt Risk Premium
Debt spread

0.8
3.50%
6,500
6,000
4%
5.5%
2.5%

0.85
2.50%
5,500
5,000
4%
5.5%
2%

0.7
4.5%
1,000
1,000
4%
5.5%
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
Cash
Accounts receivable
Other short term assets
Property, plant and equipment
Total

Liabilities
100000 Accounts payable
900000 Short term secured debt
5100000 Long term bank debt
8000000 Shareholders equity
14100000 Total

1000000
100000
9000000
4000000
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

Without synergy

With Synergy

Revenues
- COGS
- Deprecn
= EBIT
EBIT (1-t)
- WC
FCFF

$4,620
$4,043
$200
$378
$245
$22
$223

$3,281
$2,920
$74
$287
$187
$16
$171

$7,901
$6,963
$274
$664
$432
$38
$394

$7,901
$6,795
$274
$832
$541
$38
$503

Cost of Equity
Cost of Debt
WACC

12.50%
5.53%
11.98%

12.50%
5.53%
11.38%

12.50%
5.53%
11.73%

12.50%
5.53%
11.73%

Firm Value
$3,199
Firm Value = FCFF1/(WACC - g)

$2,681

$5,879

$7,479

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

Question 6
EBIT
Min EBIT int coverage ratio
Interest capacity
Interest rate

15

2
8
11.50%

Debt capacity

65

Question 7.
Estimating borrowing capacity

Possible capital structure

Given:
EBIT
Min EBIT int coverage ratio
Interest capacity
$
Interest rate
Debt capacity
$

Debt
Mezzanine
Equity
Total financing

11
2
6

Before
120

After
48

30

30
78

150

11.50%
48

Pre-restr debt value:

Banks might takeDebt
Equity
Value

61.8
48
20
68

Question 8
.
Estimating borrowing capacity

Preliminary capital structure

Given:
EBIT
$
Min EBIT int coverage ratio
Interest capacity
$
Interest rate
Debt capacity
$

Debt
Mezzanine
Equity
Total financing

139

$
$

111
250

Dividend?
Tax shield gain?
PV tax shield gain?
Assumes growth
WACC

32
2.20
15
10.50%
139

Equity value:
Shares
$
Dividend
$
Tax shield $
Gain of

Question 9.
Breaking Up is Hard

EBITDA
Tax rate
Beta
Growth rate
Equity
Debt

Existing
Estimated
Amtrak Amrak sans stations
475.00 $
375.00 $
30%
30%
0.8
0.85
3.50%
2.50%
6,500
5,500
6,000
5,000

Estimated
Amstation
100.00
32%
0.7
4.5%
1,000
1,000

91
2.9
39

3%
10.50%
$

241

111
91
39
19%

Risk Free
Mkt Risk Premium
Debt spread
Re
Rd
WACC
Enterprise PV
Equity PV
Additional Gains/losses

4%
5.5%
2.5%
8.40%
6.50%
6.55%
16,108
10,108

Choice

10,108

4%
5.5%
2%
8.68%
6.00%
6.54%
9,505
4,505
1,267

4%
5.5%
4%
7.85%
8.00%
6.65%
4,872
3,872
0
9,644

Question 10.
Assets
Cash
Accounts receivable
Other short term assets
Property, plant and equipment
Total

Book
Liquidation Liabilities
100000
100000 Accounts payable
900000
720000 Short term secured debt
5100000 2550000 Long term bank debt
8000000 6000000 Shareholders equity
14100000 9370000 Total

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

1000000
100000
9000000
4000000
14100000