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Learning Objectives & Instructions In this assignment you will analyze the proposed change in the financial policy of Swedish Match. The case is set around September 2005. During this time period Lars Dahlgren, the CFO of Swedish Match, is considering a radical change in the firm's financial policy. Specifically, Dahlgren is considering whether to Increase the leverage of the firm through a bond issuance, and using the money raised from the bond Issuance to repurchase shares. As part of this assignment you will analyze whether this transaction will ultimately be to the benefit of Swedish Match's shareholders. Additionally, this assignment asks you to discuss the benefits and costs associated with debt financing. This case study is slightly more qualitative in nature compare to the last one. Therefore, it is especially Important that you read the entire case study in the course packet carefully before attempting to answer the questions below. You might have to read the case study several times to make sure you have all the Information that you need. All of the information you require to solve this assignment is in the course packet (see syllabus) You may work on this case study independently or in groups of up to four students. If you work in groups, please only hand in one copy of your write-up per group and make sure to list the full names of all your group members. You will hand in a type written copy of your write-up at the beginning of class on the due date. The first page should have the title "FIN 320 - Swedish Match Case" and list your full name(s). I will not accept late submissions or hand-written submissions, or submissions by email Please follow the following additional instructions when completing the assignment: Assume a corporate tax rate of 28% for Swedish Match Assume that Swedish Match has no excess cash Assume that if Swedish Match completes the transaction it will issue a perpetual bond with a face value of SEK 4 billion Assume that the yield on a perpetual bond equals the yield on a 30 year bond & Question 1 (5 Points) Briefly explain what factors have prompted Swedish Match to consider this radical change in its financial policy. (.e. Why are they considering this now?) A New Financial Policy at Swedish Match In early September 2005, Lars Dahlgren was weighing his options in his Stockholm office. He had recently been appointed CFO of Swedish Match, a prodocer of smokeless tobacco, cigars, matches, and lighters. Its most important product was a type of smokeless tobacco called smus (see Exhibit 1). At the next meeting of Swedish Match's audit committee, Dahlgren was scheduled to present an annual review of the financial plan. Swedish Match had recently used bank loans to finance the acquisition of several cigar firms. However, these debts were being rapidly paid off, and if the firm maintained its traditional policies, its leverage- the ratio of debt to capital - would soon be very low again. Though the board did not know it yet, Dahlgren was considering a radical proposal: a substantial increase in the firm's leverage, implemented with a Euro-denominated bond issue, and combined with an aggressive program of share repurchases. This would be a sea change from the firm's more conservative financial practices. After the audit committee meeting, Dahlgren would propose the new policy to the full board in its October meeting Swedish Match and the Match King Swedish Match had a long and dramatic history, much of it under the leadership of Ivar Kreuger. Born in 1880, Ivar Kreuger-"the Match King- was one of the wealthiest men in the world when he killed himself in March 1932. Kreuger had become wealthy by building Swedish Match into an international business empire comprised of national monopolies in safety matches. At the time of his death, Swedish Match had a globally dominant position, selling 66% of the world's matches! After graduating from the Royal Institute of Technology in Stockholm with a degree in mechanical engineering, Kreuger had traveled the world between 1900 and 1907 working in various jobs in Mexico, South Africa, and New York City, where he first learned of steel-reinforced concrete. He returned to Europe in 1908, founding a building company that applied the new construction technique. The firm, Kreuger & Toll, grew to be worth SEK 1 million by 1911. Matches were the Kreuger family business, however, and Kreuger soon turned his attention there. In 1903, Sweden had 15 match companies. Six of these merged to form Jnkping och Vulcans Tndsticksfabriks AB (J&V), controlling 80% of the Swedish match market and threatening the Kreuger family company. Using contacts in the banking industry and his construction profits, Ivar Kreuger was able to raise debt to finance an expansion of the family's company. He used bank loans to merge Sweden's nine remaining match companies in 1913 into AB T'Grenade Svenska Tndsticksfabriks (Tacenade), with Kreuger in control. During World War 1, J&V sold matches to both sides of the conflict. When the Allies (initially Britain, France, and Russia) suspended J&V import licenses, Frenade, which had sold matches only to the Allied side, benefitted. In 1916, J&V was forced to merge with Fodenade, forming Swedish Match. Ivar Kreuger had gained complete control over the Swedish market for matches. The monopoly in Sweden proved highly profitable, and Kreuger set out to replicate it elsewhere. As a first step in 1917, Swedish Match acquired majority holdings in Denmark's three match companies, but this tested Kreuger's ability to borrow in Sweden to the limit. To continue expanding Kreuger needed funding beyond the capacity of Swedish banks. In 1923, Kreuger set up the International Match Company (IMCO) in New York City as a way to raise money from American investors. Raising equity abroad threatened to put Kreuger in violation of Swedish laws that forbade foreign majority ownership of Swedish companies. To avoid this, Kreuger invented "A" and "3" share classes: B shares gave investors only a small percentage of the voting rights of an A share, allowing investors to buy stock in Kreuger's companies without violating Swedish law. Dual share classes of this type are still in common use around the world. Kreuger also pioneered the use of convertible securities - Ioans that could be repaid in cash or converted to company stock? By 1925, Swedish Match controlled significant portions of the match industries of Austria, Belgium, Finland, Hungary, Norway, the Netherlands, and Switzerland, and soon thereafter made acquisitions in Japan and the U.S. Creating national monopolies often required permission from national governments. Beginning in 1925, Kreuger began lending money to governments in exchange for monopoly control of their match markets. Ecuador, France, Germany Greece, Hungary, Latvia, Peru, Poland, and Yugoslavia all borrowed money from Kreuger, Swedish Match, IMCO, and the other companies in Kreuger's empire. Kreuger raised ever larger sums in New York. Investors were willing to supply funds for two reasons: the high and stable dividends paid to investors, and the national monopolies that sustained these payouts. Kreuger became world famous. The stock market crash in 1929 and the worsening business cycle made things harder for Kreuger. Profitability at Swedish Match faltered as the Great Depression deepened. However, Kreuger's companies continued paying high dividends to attract new investors. As money ran out, Kreuger paid dividends to his earlier investors with money received from new investors. He covered this up with fraudulent accounting practices and counterfeit documents. This worked for a while, but when Kreuger tried to sell his majority stake in the telecommunications giant Ericsson, an audit by the bankers at J.P. Morgan revealed that some assets were missing. The bank blocked the deal in February 1932, initiating one of the largest financial collapses of all time. All sources of debt funding dried up for Kreuger. The Swedish Match share price collapsed. Within a few weeks, Ivar Kreuger shot himself in a Paris hotel, generating worldwide news. Swedish Match survived. In the wake of the collapse, the companypdivested several businesses and focused on matches in Sweden. Over the next 50 years, Swedehh Match was owned by a succession of Swedish investors and business groups who operated the match business under various names. By 1992, this match business was combined with the largest Swedish tobacco company, under the Swedish Match name. The firm's owner spun off Swedish Match in an IPO in 1996. At that time, the business consisted of matches and lighters, cigarettes, and niche tobacco products (cigars, pipe tobacco, and smokeless tobacco). In 1999, the company divested its remaining cigarette operations to concentrate on niche tobacco products. The firm made acquisitions in cigars, notably of General Cigars, headquartered in Virginia, in 1999. The divestment of cigarettes was a strategic move. In the Swedish market more and more people felt there were advantages to snus, a more socially accepted tobacco product, and Swedish Match was uniquely positioned to take advantage of this growth. (Exhibit 2 shows summary financial data for the decade ending in 2004.) I Swedish Match in 2005 By 2005, Swedish Match was a worldwide leader in smokeless tobacco products including snuff snus, and chewing tobacco. The tobacco was sourced from carefully selected suppliers and manufactured in Sweden. These business segments accounted for 32% of 2004 sales and 72% of operating income. These products were most popular in Scandinavia and the United States, Snus had been banned in the EU since 1992, but it remained legal in Sweden. Its sale was also allowed in Norway, which remained outside the EU. The EU debated the regulatory status of snus, and a general trend emerged of increased tobacco restrictions as well as concern about possible future regulatory restrictions. However, some analysts argued that snus faced lower regulatory risks than cigarettes because the health risks were different In Sweden and Norway, about one million people used snus in 2004, and Swedish Match controlled 96% of the market. In Scandinavia, popular snus brands such as General, Gteborgs Rape, Ettan, and Catch held a dominant market position. Sweden was unique in the EU with its low prevalence of cigarette smoking. Among Swedish men, the use of snus was more common than smoking cigarettes. Growth was also stimulated by the fact that the EU decided to remove the cancer warning from the snus can in 2002. With attractive margins and strong growth prospects, several competitors surfaced during this time on the Swedish market. wat for smokeles tobacco products with over 900 The United States was the biggest growth market for smokeless tobacco products, with over 900 million cans of snuff and snus sold in the US, in 2004. In the United States, Swedish Match offered moist stuff brands Longhorn and Timberwolf and the snus brand General. The primary brands competing in the U.S. market included Grizzly, Hawken, and Kodiak, all produced by American Snuff Company, and Red Seal, Copenhagen, Rooster, and Skoal, produced by US Smokeless Tobacco Company. Demand for snus and moist snuff was growing in the US in 2004, as more people chose smokeless tobacco over cigarettes. Red Man, Swedish Match's chewing tobacco brand, was sold only in the United States and was the market leader, with a 43% market share in 2004, and Swedish Match was hoping for further growth of snus products.10 After smokeless tobacco, Swedish Match's most important single product was cigars, which comprised 24% of sales and 59% of operating income in 2004. Swedish Match was the world's number two cigar manufacturer, and the global leader in the premium segment of the US market." Swedish Match produced both machine-made and premium cigars. Premium cigars, which were made by hand, mostly in Latin America and the Caribbean, accounted for 24% of Swedish Match's sales volume, and 20% of operating income in 2004. The market for machine-made cigars in the United States and Westem Europe was estimated at about 13 billion cigars per year, of which Swedish Match supplied about 7%. Flavored cigars were considered the segment with the largest growth potential.12 Chewing tobacco, a stagnating product category sold mostly in the US, generated 8% of sales and 13% of operating income in 2004 In addition to snus, snuff chewing tobacco, and cigars, Swedish Match also produced pipe tobacco, although this was a declining market (it shrunk 14% in US. sales volume in 2004, for example). Pipe tobacco accounted for about 9% of the company's operating income. Swedish Match maintained a 16% market share in the US, and profitability for pipe tobacco remained strong." Finally, matches accounted for just 11% of the company's sales in 2004 and 1% of operating income." Overall, Scandinavia, the US, and the rest of the world each represented approximately one-third of company sales. Costs matched revenues fairly well, so the net currency exposure of Swedish Match was low Swedish Match had a conservative policy in all financial matters. At the time of the firm's IPO in 1996, management had decided to target book equity of at least 30% of assets (corresponding to interest-bearing debt over assets of 20%-40%, depending on the amount of non-interest-bearing liabilities). The firm paid high dividends and made some share repurchases. For a period, leverage had increased due to acquisitions in the cigar area. The company had an international short-term bond program (the "Global Medium Term Note Program") and a small Swedish bond program, both started in the late 1990s and by then largely paid off. The firm had a credit rating of A- from rating agency S&P (sce Exhibit 5 for data on ratings) A New Financial Policy Swedish Match's financial policy was set by the board of directors (see Exhibit 6 for a list of members). In accordance with Swedish law, two labor representatives were voting members on the board. Swedish Match's president and CEO, Sven Hindrikes appointed in 2004, was also a member of the board. Hindrikes had asked Dahlgren to propose a detailed financial policy first to the board's audit committee and then to the full board in its October 25 meeting the board would decide on a Anancial policy, including how to measure leverage and what targets to apply Several factors played into Dahlgren's sense that this was a good time to reconsider the company's financial policies. First, Sweden had recently instituted a new corporation law that allowed firms to repurchase shares even if it resulted in negative consolidated book equity for the group. Second, a continuation of the current policy would reduce leverage in the next few years. In Dahlgren's view, Swedish Match faced several potential benefits of taking on more debt. Leverage reduced the corporate income tax bill. As in the United States and many other countries, interest expenses were deductible from corporate income under Swedish tax law. The corporate income tax rate was 28% where it was expected to remain. There were other advantages to higher leverage. Some viewed excess cash or debt capacity negatively, seeing them as potentially leading to waste and inefficiency. the art of issuing new debt might be seen as a sign of strength. Institutional investors un large owners earlier that year, Further, the act of issuing new debt might be seen as a sign of strength. Institutional investors seemed to agree with a more aggressive policy. In a survey of some large owners earlier that year, several had expressed support for increased repurchases. A Citibank analyst reported, "we expect the company to buy back SEK 9-12 billion in shares by the end of 2007." Dahlgren also felt that the lack of explicit financial targets created unnecessary uncertainty. Finally, looking to international peers (see Exhibit 7 for selected financials), Dahlgren noticed that many of them maintained high leverage. In contrast, Dahlgren also ticked off the disadvantages of debt in his head. Net income would be lower, because some of the firm's cash flows would go to interest payments. Raising new debt might also expose the firm to bond market conditions when needing to refinance. Additionally, taking on more debt would reduce financial flexibility going forward. Dahlgren also had to consider the risk to the firm's business. If the smokeless tobacco products faced more competition, the ability to pay interest payments or principal could be in doubt . A forced sale of assets, or even bankruptcy, was a possibility. Credit rating agencies would lower Swedish Match's credit rating accordingly. Dahlgren and finance vice president Joakim Tilly discussed a bond issue in the European market, given the modest size of the Swedish bond market. Based on conversations with bankers in London, they felt that bond issues below 300 million, or approximately SEK 3 billion, would be impractical and expensive to issue. Such a bond would have interest and principal repayments in euros, but it would be fairly easy to swap those payments with a bank so that Swedish Match could pay interest in SEK. The effective interest rate after swapping was expected to be similar to euro rates . Analysts expected EBITDA to be around SEK 3 billion per year in the next few years. Given this, Dahlgren and Tilly thought that a BBB+ rating would be sustainable under as much as SEK 4 billion of additional debt. Swedish Match's board wanted to be conservative, and thought that it was important to be prepared for a worst-case scenario where profitability dropped by as much as half. Dahlgren and Tilly thus felt it was prudent to consider a temporary drop in EBITDA to as low as SEK 15 billion. Swedish Match shares were currently trading at SEK BO in Stockholm, slightly up over the year to date. Decision Dahlgren and Tilly believed that sensitivity analyses theoretical valuation impacts, signaling considerations, and the availability of financing should be key inputs into the decision. Dahlgren claborated: "Financial risk can ultimately be defined as the risk for a company of either failing to pay the interest on its loans or failing to pay back the entire principal at maturity traditional solvency ratios such as equity over total assets poorly reflect these risks" Instead, he felt that a policy that targeted a rating such as BBB+, a reasonable interest coverage ratio, and suitable market leverage would provide a better target for the firm. Under this approach, he felt that substantially higher leverage could be maintained. Taking on more debt and repurchasing shares might involve pushing book equity below zero, but the new corporation law was widely understood to allow this, and Dahlgren felt that financial analysts and investors would not find this unsettling Yet Dahlgren understood that the board would raise several concerns about the proposal. Would the new leverage affect the firm's ability to undertake acquisitions? Would the firm's ability to repay its debt be robust even in a cyclical downturn? Dahlgren would need to address all of these concerns in the upcoming meeting. As Dahlgren considered the pros and cons of a new financial policy, he also pondered the appropriate amount and structure for a bond issue. Exhibiti Swedish Match Snus Products General General -- Gew Source Swedish March, 2004 Annual Report Exhibit 2 Swedish Match, Selected Financial Data, 1995-2004 in SEK millions, except where noted) 3855 8154 2.000 6.667 wi 1473 1.SI 2.300 2.15 EBITOA EBIT 13.00 7.007 3.6 2.344 470 1.865 200 270 6.14 304 1.99 1.578 18 2.125 2.174 512 so 1545 2,083 Se 5.015 18281 3.002 4 2.712 4.300 14.096 2.770 3520 2.55 40 3.4 12 1997 1998 2001 2003 2000 Summary Operating Data Revenue Cost of Goods Sold 7435 7416 7,465 11.50 13,635 1363 3.500 13.036 3.615 -Omer Operator Experts 4,096 7. 2012 2.179 2201 7451 7.100 3,035 3.03 3.02 184 3.722 Depreciation and Action 07 1.560 1478 294 SG 2211 670 1.173 1,314 651 000 - Expense 1.301 14N 107 178 65 - 1.546 65 504 182 222 407 337 ENT 280 234 809 752 1330 754 1.550 --Income Taxspense 911 473 1.710 1.540 450 Net Income 102 556 640 572 1.103 1,001 1,000 716 1,154 Balance Sheet Cash and Short-term stets 304 942 Current Assets 2,878 2.560 1.000 3090 2016 2.680 3.100 PPLE 3.278 4089 5,730 6.567 2002 1.900 5310 2.050 Other As 2.230 2.570 2970 2.939 2002 741 330 21 Total Assets 1,358 3.000 4751 6.646 877 4254 7,132 10,562 16.623 15.41 15,102 Current 2.790 2.732 3.25 Total Interest Bearing Dett 3,093 2.900 129 1,019 of which Long-term Debt 200 4.331 5.000 5.400 9 5.203 5.381 Other Lab 2.09 4.600 50 4535 802 1 1191 2.125 2,370 2.185 Equity, indung mit dem 1862 2 2.092 2,308 5.204 4872 4.60 Total Liabilities and Equity 6.646 6.877 7.132 10,562 16.261 1603 15.47 15102 Cash Flow Data and Stock Price CErenditures 302 217 292 393 331 633 750 551 Can Acoustine O 0 00 157 Dividends Paid 53 1.072 300 1.680 510 510 78 539 400 500 Share Repurchases 0 $35 0 0 1.147 106 1.100 499 1012 Shares standing, M 464 464 431 375 350 354 325 Year End Share Prioresha 29.7 206 20.28 2552 42.52 00.00 6198 787 Market value of Equity 12.801 12.331 12.192 10.000 15.044 24.150 2001 2856 Selected Grow Rates and Ratics EBITDA Marin 198 21.4 21 ON 18 ON 16.04 159 172 17 ON ESIT Margin 15. 17. 17 4N 14.09 113 110 125 11. Book Leverage (debidebitus quity) 72 30.1% 6.5 852 523 530 50% 50 Market Leverage de plus mantap 10 7.0 1.7 28 26 185 2035 12 Book Equity Assets 250 344 12.0N 2199 20% 29 3045 Source Capital 2011, and anal por Other itemindudentment Inc. Income from Am Curry dan Gainestructuring Charge Canon Soft Weite-dows Other Umum Cindude Account Reviewery, and opene 3.579 3072 2.300 200 500 200 5.000 14.30 TIN 20. Manager 2001 DOMINIQUE BADGER UND 400 -64 550 437 3221 88 34 28.454 14 4115 11 ON 34 ON 305 Exhibit 3 Swedish Match Share Price Performance Relative to Sweden's Primary Share Index, January 2, 1997-September 1, 2005 100 90 80 70 60 50 40 Swedish Krona (SEK) 30 20 10 o 1661 TOOR 1/2/1997 12/1999 1/2/2000 12/2001 1/2/2004 SOC/C/ 1/2/2002 SWEDISH MATCH OMX STOCKHOLM 30 SMI Exhibit 4 European Corporate Bonds, Constant Maturity Yields by Credit Rating January 2005 3-month 6-month Maturity 5-year 1 year 10-vear 20-year 30-year Credit AAA AA A BBB Benchmark 2.179 2.246 2284 2.463 2.065 2.218 2.262 2.336 2.484 2.119 2348 2.389 2.474 2 688 2.225 3.150 3.269 3349 3.819 3.028 3.762 3.918 4.024 4.541 3.695 4.394 4.612 4.624 5.151 4.293 NA 4.539 4.970 5.077 4.383 Source Bloomberg, accessed September 2011 Benchmark interest rate refers to the average of euroa AA-cated government debt (sovereign bonds and by France and Germany) Exhibit 5 U.S. Industrial Firms, Aggregate Average Financial Ratios by Credit Rating 2002-2004 Credit Rating A BA AAA AA B 50 EBIT interest coverage (80) EBITDA Interest coverage Total debUEBITDA (X) Market leverage (debt debt plus market capitalization (56) 23.8 25 5 0.4 19.5 24.6 0.9 8.0 102 1.6 NO NO 4.7 6.5 22 25 3,5 3.5 1.2 1.9 5.3 0.4 0.9 7.9 3.1 72 16.1 245 35 5 535 78.2 Candiese Get Adil Key US Industrial Financial Ratios Exhibit 6 Swedish Match's Board of Directors, August 2005 Bernt Magnusson: Chairman of the Board Jan Blomberg Former CFO, Pharmacia Kenneth Ek Labor representative 7 Sven Hindrikes: President and CEO Tuve Johannesson: Former president, Volvo Cars Arne Jurbrant: Former CEO, Kraft Foods Nordic Region Labor representative Eva Larsson: Joakim Lindstrm: Labor representative Karsten Slotte: President and CEO of snack food company cloetta Fazer Kersti Strandqvist Business area manager, SCA Baby Care Meg Tiveus: President lottery operator Svenska Spel Exhibit 7 Comparable Company Data, 12/31/2004 (in SEK millions, except as noted) Swedish Match UST Imperial Tobacco BAT Gallaer Altadis 13.007 2,344 1.865 266 2,083 28% 11,888 6,377 5,060 551 3.527 36,447 15.915 12.189 2,741 5.349 73% 137,096 36,528 31,982 4.723 35.993 30% 32 423 8.811 7,677 1,974 4.550 55% 86,460 9.624 8.112 1.490 65% 4.15 45% 3,390 11.027 Summary Operating Data Net Sales EBITDA EBIT Interest Expense Net Income Dividend Payout Ratio Balance Sheet and Cash Flow Data Cash and Short-term Investments Total Assets Total Debt Non interest Bearing Liebe Total Equity Stock Price Data Price Earnings Ratio Equity Market value Select Ratios Sales Growth EBITDA Margin Leverage at Book Values (debudebt plus equity) () Leverage at Market Values (debt debt plus market cap) (%) EBIT interest Coverage 3 EBITDA Interest Coverage (x) Total Debt EBITDA X) 3,002 14.898 3.520 6,309 5.000 8.238 4,010 77.262 50,540 23.064 3.000 24.662 226,308 01353 57,074 77.881 9.689 55,154 37.831 18.087 -764 0.954 96.440 27.720 55093 12.833 2.726 04 142 28.454 15.0% 52,823 23.4 131.484 176x 233,607 17. 65.865 23.1 88425 25 -0.2% 185 415 5.3% 54% 99% 53% 44% 94 18% 279 54% -15% 27% 102 68 11% 13% 28% 28% 36% 24% 70 88 1.5 11.0 110 44 58 32 7.7 2.5 3.9 4.5 43 5.4 6.4 29 Credit Rating A. BBB BBB. BBB A