PROBLEM 10–6 As a new employee of Clayton Asset Management, you are assigned to evaluate the credit quality of BRT Corp. bonds. Clayton holds the bonds in its high-yield bond portfolio. The following information is provided to assist in the analysis.

1. BRT Corporation is a rapidly growing company in the broadcast industry. It has grown primarily through a series of aggressive acquisitions.

2. Early in Year 6, BRT announced it was acquiring a competitor in a hostile takeover that would double its assets but also increase debt. The credit rating of BRT debt fell from BBB to BB. The acquisition reduced the financial flexibility of BRT but increased its presence in the broadcasting industry.
3. In the middle of Year 7, BRT announced it is merging with another large entertainment company. The merger will alter BRT’s capital structure and also make it the leader in the broadcast industry. The Year 6 acquisition combined with this merger will increase the total assets of BRT by a factor of four. A large portion of the total assets are intangible, representing franchise and distribution rights.
4. While the outlook for the broadcasting industry remains strong, large telecommunication companies attempting to enter the broadcasting industry are keeping competitive pressures high. Laws and regulations also promote the competitiveness of the environment, but initial start-up costs make it difficult for new companies to enter the industry. Large capital expenditures are required to maintain and improve existing systems as well as to expand current business.
5. For your analysis, you are provided with the financial data shown here:
BRT CORPORATION Balance Sheet Data (in millions)
At December 31 Projected Year 3 Year 4 Year 5 Year 6 Year 7 Current assets ........................ $ 654 $ 718 $2,686 $ 2,241 $ 5,255 Fixed assets, net ..................... 391 379 554 1,567 2,583 Other assets (intangibles) ...... 2,982 3,090 3,176 8,946 20,435 Total assets............................. $4,027 $4,187 $6,416 $12,754 $28,273 Current liabilities.................... $ 799 $ 876 $ 966 $ 1,476 $ 3,731 Long-term debt ....................... 2,537 2,321 2,378 7,142 15,701 Other liabilities ....................... 326 292 354 976 349 Total equity ............................. 365 698 2,718 3,160 8,492 Total liabilities and equity....... $4,027 $4,187 $6,416 $12,754 $28,273 BRT CORPORATION Income Statement Data (In Millions Except per Share Data)
For Year Ended December 31 Projected Year 3 Year 4 Year 5 Year 6 Year 7 Net sales.................................... $1,600 $1,712 $2,005 $4,103 $9,436 Operating expenses ................... (1,376) (1,400) (1,620) (3,683) (8,603)
Operating income ...................... 224 312 385 420 833 Interest expense......................... (296) (299) (155) (270) (825)
Income taxes.............................. (20) (42) (130) (131) (4)
Net income................................. $ (92) $ (29) $ 100 $ 19 $ 4 Earnings per share .................... $ (0.86) $ (0.24) $ 0.83 $ 0.09 $ 0.01 Average price per share ............. $26.30 $34.10 $44.90 $40.10 $40.80 Average shares outstanding ...... 107 120 121 198 359 BRT CORPORATION Selected Ratios Projected Year 3 Year 4 Year 5 Year 6 Year 7 Operating income to sales ............. 14.0% 18.2% 19.2% 10.2% *
Sales to total assets ...................... 0.39 0.41 0.31 0.32 0.33 Earnings before interest and taxes to total assets.................. 5.5% 7.4% 6.0% 3.3% *
Times interest earned .................... 0.76 1.04 2.48 1.55 *
Long-term debt to total assets ...... 63.0% 55.4% 37.0% 55.9% *
CLAYTON ASSET MANAGEMENT Credit Rating Standards AVERAGE RATIOS BY RATING CATEGORY Financial Ratios AA A BBB BB B CCC CC Operating income to sales (%) .......... 16.2 13.4 12.1 10.3 8.5 6.4 5.2 Sales to total assets .......................... 2.50 2.00 1.50 1.00 0.75 0.50 0.25 Earnings before interest and taxes to total assets ............................... 15.0% 10.0% 8.0% 6.0% 4.0% 3.0% 2.0%
Times interest earned ........................ 5.54 3.62 2.29 1.56 1.04 0.79 0.75 Long-term debt to total assets .......... 19.5% 30.4% 40.2% 51.8% 71.8% 81.0% 85.4%
Bond Credit Spread Information Current yield spread in basis points over 10-year Treasuries................. 45 55 85 155 225 275 350 Required:

a. Calculate the following ratios using the projected Year 7 financial information:
(1) Operating income to sales. (3) Times interest earned.
(2) Earnings before interest and taxes to total assets. (4) Long-term debt to total assets.

b. Discuss the effect of the Year 7 merger on the creditworthiness of BRT through an analysis of each of the ratios in (a).

c. BRT Corporation 10-year bonds are currently rated BB and are trading at a yield to maturity of 7.70%. The current 10-year Treasury note is yielding 6.15%. Based on your work in

(a) and (b), the background information, and information on Selected Ratios and Credit Rating Standards, state and justify whether Clayton should hold or sell the BRT Corporation bonds in its portfolio. Include qualitative factors in your discussion.