CASE STUDY - Reebok Ltd.

Mort Moore founded Reebok Ltd. after returning from duty in the South Pacific during

World War II. Before joining the armed forces, he had worked for a locally owned plumbing

company and wanted to continue with that type of work once the war effort was over. Shortly

after returning to his hometown of Minneapolis, Minnesota, he became aware of an

unprecedented construction boom. Returning solders needed new housing as they started

families and readjusted to civilian life. Mort felt that he could make more money by

providing plumbing supplies to contractors rather than performing the labor, and he decided

to open a plumbing supply company. Morts parents died when he was young and was raised

by his older brother, Stan, who ran a successful shoe business during the 1920s. Stan often

shared stories about owning his own business and in particular about a large expansion that

was completed just before the market collapsed. Because of the economic times, Stan lost the

business but was lucky to find employment with the railroad. He dutifully saved part of each

paycheck and was so thankful that his bother returned home safely that he decided to use his

sizable savings to help his brother open his business. Mort kept in mind his brothers failed

business and vowed that his company would operate in such a way that it would minimize its

vulnerability of general business downturns.

Moores extensive inventory and reasonable prices made the company the primary supplier

of the major commercial builders in the area. In addition, Mort developed a loyal customer

base among the home repair person, as his previous background allowed him to provide

excellent advise about specific projects and to solve unique problems. As a result, his

business prospered and over the past twenty years, sales have grown faster than the industry.

Because of large orders, the company receives favorable prices from suppliers, allowing

Reebok Ltd. o remain competitive with the discount houses that have sprung up in the area.

Over the years, Mort has kept his pledge and the company has maintained a very strong

financial position. It had a public sale of stock and additional stock offers to fund expansions

including regional supply outlets in Milwaukee, Wisconsin and Sioux City, Iowa.

Recently, Stan decided that the winters were too long and he wanted to spend the coldest
months playing golf in Florida. He retired from the day-to-day operations but retained the

position of President and brought in his grandson, Tom Moore, to run the company as the

new Chief Executive Officer. Tom was an excellent choice for the position. After graduating

summa-cum laud with a degree in communications from the University of Wisconsin, he

worked in the Milwaukee operation where he was quickly promoted to manager. In ten years,

sales quadrupled under his leadership and employees remained loyal. He was familiar with

the supply and demand of various components and was able to spot new trends in the

industry before they became widely accepted. Although he had developed a keen sense of

financing working capital, he had no background in higher-level corporate finance

decisionmaking.

Tom spent the first few months on the new job trying to get a better handle on the

bigger picture and puzzled over the companys historical balance sheets, income statements

and cash flow statements. One area that concerned him was the companys heavy reliance on

equity financing. Reebok Ltd. has a large line of credit and uses this and short-term debt to

finance its temporary working capital requirements. However, it does not use any permanent

debt capital. Other construction related retail and wholesale companies have between 30 and

40 percent of their long-term capitalization in debt. Tom wonders why other companies use

more permanent debt and what affect adding long-term debt would have on the companys

earnings and stock price.

Tom met with the companys vice president of finance, Walt Harriman, and learned that the

company projected its earnings before interest and taxes to be Rs.12 million for the next year

with virtually no interest expenses. Walt also mentioned that he expected the companys

current and projected tax rate to be 40 percent. Tom next talked to the companys investment

bankers and discovered that the companys cost of equity was 16 percent. Since the company

did not use debt or preferred stock financing, this also represented the companys current

weighted average cost of capital. The investment bankers indicated that the company could

issue at least Rs.30 million of long-term debt at a cost of 9 percent. The company bonds

would be highly rated and would carry a low coupon because the company could easily

service the debt.

Because of Stans depression experience and his early involvement in funding the initial

operation, the company not only avoided debt but also followed a policy of paying out most

of its earnings as dividends. Stan was frequently quoted saying a company with high

dividend policy rarely declared bankruptcy. In lieu of using retained earnings to reinvest in

the company, the company used accounts payable and deferred taxes to meet its operating

capital needs and issued new equity capital when additional financing needs were

exceptionally high. Much of the new capital was purchased by members of the Moore family

and they currently hold 75 percent of the outstanding equity.

Tom is interested in gaining additional insights into capital structure issues and has asked

Walt to brief him in the area. He wants a basic review of the terminology but is particularly

interested in the impact of different types of risk and in understanding of the better-known

financial theorists. Walt knew that Tom could grasp complex issues quickly and felt that a

thorough discussion of Modigliani and Millers work would be appropriate. He also felt that

Millers addition of personal taxes to the earlier models would be good to cover, and he

determined that a good approximation of personal tax rate on debt income was 28 percent

and for stock income was 20 percent. He decided to add the more recent considerations of

financial distress, agency costs and information asymmetry for a comprehensive overview.

To help with this analysis, Walt developed the following estimates for cost of debt and cost

of equity that included an increasing premium for financial distress and agency costs as the

debt ratio increases.

Read the case carefully and answer the following questions.

Q1. What is meant by capitalization? What is meant by a firms capital structure? For
financial

planning purposes, explain why either book or market value should be used to determine the

firms capital structure. What is capital structure theory?

Q2. Discuss the following issues relating to business risk and financial risk.

(a.) What is the difference between business risk and financial risk? Explain some of the

factors that contribute to each. Evaluate Reebok Ltd. Supplys level of business risk.

(b.) How does this risk relate to total risk?

(c.) How does business risk affect capital structure decisions?

Q3. Using Moores projected EBIT of Rs.12 million, and assuming that the MM conditions
hold,

compare the value of the company as an unlevered firm (VU)with a 16 percent cost of equity

(ksU) with the value of the firm if it had Rs.30 million of 9 percent long-term debt.

(a.) What are the values for the unlevered firm (VU), the levered firm (VL),and the cost of

equity for the levered firm (ksL)?

(b.) Based on MM without taxes, what is the companys cost of capital if it uses debt

financing? Use the formula WACC formula to verify that the leveraged firms cost of

capital.

Q4. Miller added personal taxes to the model in his 1976 Presidential Address to the
American

Finance Association.

(a.) What is Millers basic equation (his Proposition I)?

(b.) According to the Miller model and assuming that tc is the corporate tax rate at 40

percent, td is the personal rate on debt income at 28 percent,and ts is the personal tax

rate on stock income at 20 percent, what is the value of the unlevered and levered firm

and what is the gain from leverage? How does this compare with the MM gain from

leverage, where only corporate taxes are considered?

SOLUTIONS

(1.)

Capitalization represents the capital required to fund a companys operations. In practice, it

generally refers to total long-term debt, preferred stock, and common stock. Companies with

a high-risk tolerance may use some short-term debt to fund their longterm capital needs as it

generally has a lower cost. However, it is more sensitive to risk from changing interest rates

and funding availability. Capital structure is the mix or proportion of debt and equity

financing used by the company to fund their assets. In the theoretical literature, capital

structure generally refers to the entire right-hand side of the balance sheet, and discussion of

it focuses on 1) the proportion of debt and equity and 2) the maturity structure of the debt.

Although business executives generally describe everything in book or accounting value,

financial theorists concentrate on market value. Book value of debt and equity are historical

values based on prices at the time the company obtained the capital. Changing rates and

economic conditions will affect the market prices of stock and bonds and change these

values. Since financial planning is forward rather than historically focused, and the market

represents the relevant value for investors, market values are more representative of the

companys capital structure.

Capital structure theory refers to the body of literature that attempts to establish the

relationship between a firms capital structure and 1) its stock price, and 2) its cost of capital.

This theory can provide insights into the benefits and costs related to debt financing; hence, it

could help financial managers choose the optimal capital structure for their firms.

(2. a.) Business risk is the risk faced by a firms stockholders if the firm uses no debt

financing. It can be thought of as the uncertainty inherent in the firms operations or

return on assets. Business risk varies from industry to industry and relates to the

companys ability to generate revenue to cover fixed and variable costs of operations.

Business risk is affected by such things as competition, uncertainty earnings resulting

from prices, input costs, demand or sales, exposure to liability, new *product

development, and fixed operating costs. Financial risk is the additional risk borne by

stockholders because of the use of debt. It relates to the companys need to cover the

additional fixed cost of financing. Financial risk depends on the amount of fixed charge

financing (debt and preferred stock).

Reebok Ltd. Supply has a moderate level of business risk. They have steady growing

sales and are able to compete with the discount stores in the area. However, the

construction industry, to which Reebok Ltd. Supply is closely tied, is very sensitive to

general economic conditions. When the economy is in a recession, the construction of

new commercial and residential building and home remodeling are sharply reduced, and

this would have a large impact on sales. As a retail operation, a large portion of Reebok

Ltd.s assets is tied up in inventory and not in fixed assets. In addition, the company

would not have a large exposure to high cost legal suits.

(b.) The companys total risk is made up of business risk and financial risk. In the total risk

sense, one common measure of business and financial risk is the variability or ROE,

often expressed as the standard deviation. An otherwise identical but unleveraged firm

would have a smaller standard deviation or ROE than a leveraged firm would. The

difference is a measure of financial risk.

(c.) Business risk is the single most important determinant of a firms optimal capital

structure. The greater the risk inherent in a firms assets, the greater the probability of

financial distress for the firm at any debt level. Because total risk equals business risk

plus financial risk, a company with high levels of business risk cannot afford to take on

a lot of financial risk. If the company has a lot of uncertainty about its ability to meet

operating costs, it cannot afford the added risk of needing to cover high fixed cost of

financing. Also, for greater business risk, kd and ks would increase more quickly with

an increase in the firms debt ratio. Thus, high (low) business risk results in an optimal

capital structure with a low (high) debt ratio.

(3. a.) If unlevered, VU = EBIT/KsU = Rs.12,000,000/.16 = Rs.75,000,000.

If levered, by Proposition I, the value remains unchanged: VL = VU = Rs.75,000,000.

To find the cost of equity for a levered company (KsL), first find the market values of

debt and equity. The value of debt is given as Rs.30,000,000 and the value of the firm is

debt plus equity. Therefore, the value of equity is the value of the firm less the value of

debt or Rs.45,000,000(= 75,000,000 30,000,000). By proposition II, the cost of equity

is the cost of equity for an unlevered firm plus a leverage premium:

KsL = KsU + (KsU - Kd) (D/S)

= 16.0% + (16.0% 9%)30,000,000/45,000,000

= 16.0% + 4.67% = 20.67%

(b.) From Proposition I, KsU = WACC = 16 percent for all firms in this risk class, regardless

of leverage. This can be verified using the WACC formula.

WACC = wd Kd + ws Ks

WACC = (D/V)kd + (S/V)Ks

= (30,000,000/75,000,000)9% + 45,000,000/75,000,000)20.67%

= 0.40 (9%) + 0.6 (20.67%) 3.6% + 12.4% = 16.0%

(4. a.) Millers basic proposition is represented by the following two formulas.

VU = [EBIT(1 tc)(1 ts)]/ksU

In addition to the corporate tax adjustment found in the MM model, the Millers model

includes an adjustment for personal taxes paid by the investor for their equity income.

Thus, Vu is further reduced from the MM with corporate taxes model.

VL = VU + [1(1 tc)(1 ts)/(1 td)]D

Here the tax term in the MM model is replaced by the bracketed term. The second term

in the equation represents the effect from leverage and results from the cash flows

associated with debt financing (under the MM model it is assumed to be risk free).

(b.) With tc = 40%, td = 28%, and ts = 20%, the Miller model indicates thevalue of the

unlevered and levered to be as follows.

Value of unlevered firm

VU = [EBIT (1 tc)(1 ts)]/KsU

= Rs.12,000,000 (1 .4) (1 .20)]/.16

= Rs.36,000,000

Value of levered firm

VL = VU + [1 (1 tc)(1 ts)/(1 td)]D

= Rs.36,000,000 + [1 (1 .4) (1 .20)/(1 .28)] Rs.30,000,000

= Rs.36,000,000 +.3333 (Rs.30,000,000)

= 46,000,000

The gain in leverage under the Miller model is Rs.46,000,000 Rs.36,000,000 =

Rs.10,000,000. In contrast, if only corporate taxes were considered, we have Vu =

Rs.45,000,000 and VL = Rs.57,000,000 (from question 5), and the gain from leverage

for Rs.30,000,000 and debt is Rs.12,000,000. Thus, the gain from leverage when

considering personal taxes in the Miller model is less than the gain found using just

corporate taxes under the MM model.

The net effect of the Miller model depends on the relative effective tax rates on income

from stocks and bonds, and on corporate tax rates. The tax rate on income from stocks

is reduced if the company retains more of its income and thus provides more capital

gains. If ts declines while tc and td remain constant, the slope coefficient, or benefit of

debt, is decreased. Thus, a company with a high payout ratio gets greater benefits from

debt under the Miller model than does a company with a low payout, assuming that the

cost of equity is not affected directly by dividend policy (which MM also assumed).