2. Examine how large GKG's potential costs of financial distress. To do so, assess how vulnerable GKG is to having its value reduced by being in financial distress due to the following factors. Use information from the case to provide one or two sentence answers to these questions: A. Does GKG rely on a specialized work force that may leave the firm if it was in distress? If so, would these workers be hard to replace? B. Does GKG rely on specialized suppliers that may cease producing custom inputs if GKG were in distress? If so, would these inputs be costly to replace? c Does GKG depend on a dealer network to sell its product? Are these dealers likely to switch to selling other products if GKG was close to distress? Would these dealers be costly to replace? D Do GKG customers expect continuing support? Is it likely that customers would switch to another product if they thought that GKG was close to distress (i.e. anticipating that GKG would possibly be less likely to provide support in the future)? Is it likely that GKG is vulnerable to competitive attack if it were in financial distress? Are there other firms who have a strong incentive to compete aggressively (e.g. lower prices, increase advertising etc.) in an attempt to exacerbate distress at GKG and hopefully push it out of the market? Does GKG need access to the capital markets to fund future growth opportunities? Does GKG stand to lose considerable value by having to forgo or postpone high NPV activities if it were in distress and unable to raise new finance? G. Does GKG have many assets that would be sold in liquidation? If GKG were forced to sell assets in the event of liquidation, is it likely that these assets would have to be sold below their "normal" (e.g. long run) market value? This may occur for example if there are only a few buyers for these assets (specialized assets vs commodities) or if it is likely that other firms will be selling their assets at exactly the same time and hence temporality flooding the market. H. On balance, is GKG's overall vulnerability low, medium, or high? Ex_1 Ex_2 Ex_3 Ex_4 EXHIBITI Selected Financial Data for Global Kitchen Gadgets Corporation 1972-1981 1981 1980 1979 1978 1977 1976 1975 1974 1973 1972 $3,062.6 436,6 $2.685.1 322.9 $2.2586 248.4 8.4 $2,048.7 194,6 $1.784.4 142.8 6.8 $1,587.1 119,0 6.3 13.7 103 7.5 Sales (Small) Cash Total Debt Net Worth Total Assets (Smill) Net income ( mill) Earnings per share Dividends per share $4,1312 729.1 16.6 1654.5 2588.5 4973 3.18 $1.90 $3,798.5 593.3 13.9 1472.8 2370,3 445.9 2.84 $1.70 $3,406,3 493.8 10.3 1322 2090.7 396 2.51 S1.50 1178 1862.2 348.4 2.21 $1.33 1035.3 16113 306.2 1.94 $1.15 $2,471.7 358.8 7.8 991.5 1510.9 277.9 1.75 $1.00 1390.7 250.7 1.58 $0.90 1241.6 225.6 1.42 $0.78 1126 1992 1.25 50.63 1042 172.7 1.08 $0.59 Annual Growth in Sales Annual Growth in EPS Dividend Payout Ratio After Tax Profit Margin Return on Equity 8.8% 12.0% 59,7% 12.0" 30.1% 11.7% 13.1% 60.0% 11.7% 30,3% 11.19 13.6% 59.8% 11.6" 30.0% 14.1% 13.99% 60.0% 11.4% 29.6% 8.6% 10.9% 59.3% 11.4% 29.3% 9.4% 10.8% 57.1% 11.2 28.0% 10.2% 11.3% 57.0" 11.1% 27.9% 14.8% 13.64 54.7% 11.0% 28.2% 12.4% 15.7% 50.0" 11.296 28.2% 54.6% 10.99% 25.9% 267.5 EXHIBIT 2 Comparison Data for American Home Products and Warner-Lambert, 1980 (S in million except for per share and ratio data) Sales 5-yr compound annual growth rate Profit after tax 5-yr compound annual growth rate Global Kitchen Gadgets Corp. $3,798.5 11.0% $445.9 12.2% Lemer-Wambert Company $3,479.2 9.9% $192.7 3.3% Cash and Equivalents Accounts Receivable Inventory Net Propert, plant and equipment Other Total Assets Total Debt Net Worth $593.3 517.3 557.3 450.5 251.9 2370.3 13.9 $1,472.8 $360.3 541.5 645.8 827.1 582.5 2957.2 710.1 $1.482.7 $2.356.4 Earnings per share 5-yr compound annual growth rate Dividends per share 5-yr compound annual growth rate Stock Price (end of 1980) Price/Earnings Ratio $2.84 12.4% $1.70 13.6% S30 $2.41 3.0% $1.32 8.0% $20 8.3 10.6 Profit Margin (profit after tax/sales) Return on Equity Interest Coverage (times) Ratio of Total Debt to Total Capital Bond Rating (a) 11.7% 30.3% 436.6 0.9% AAA 5.5% 13.0% 5 32.4% AAA/AA(a) (a)Lerner-Wambert's debt was rated triple A but analysts felt the firm was close to being downgraded to double A. EXHIBIT 3 Pro Forma 1981 Results for Alternative Capital Structure (5 millions except per share data) Sales EBIT (a) Interest Profit before taxes Taxes Profit after taxes Dividends on Pfd. Stock Earnings Available to Common Shareholders Dividends on Common Stock Average Common Shares Outstanding (millions) Earnings per Share Dividends per Share Actual 1981 4131.2 954.8 2.3 952.5 428.6 523.9 0.4 523.5 Pro Forma 1981 for 30% Debt to 50% Debt to Total Capital Total Capital 4131.2 4131.2 917.5 917.5 66.3 109,3 851.2 808.2 383.0 363.7 468.2 444.5 0.4 0.4 467.8 444.1 70% Debt to Total Capital 4131.2 917.5 152.3 765.2 344.3 420.9 0.4 420.5 340.3 304.0 288.7 273.3 155.5 3.37 2.19 135.7 3.45 2.24 127.3 3.49 2.27 118.9 3.54 2.30 BEGINNING OF YEAR: Cash and Equivalents Total Debt Net Worth Common Stock Price Aggregate Market Value of Common Stock 593.3 13.9 1472.8 32.0 After recapitalization 360.3 414.5 839.2 360.3 683.3 570.4 360.3 952.1 301.6 4976.0 (a) EBIT is reduced in pro forma results due to the loss of interest income from the $233 million in excess cash used to repurchase stock. EXHIBIT 4 Detailed Assumptions for Pro Forma Recapitalizations 1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase common stock. All repurchases are assumed to be executed in January 1981. 2. Stock is assumed to be repurchased at a price of $32 per share, which was the prevailing stock price in early January 1981. 3. The minimum cash balance is assumed to be $360.3 million (equal to Lerner-Wambert's 1980 cash balance); thus $233 million in excess cash is available for use in repurchasing stock. 4. A tax rate of 45% is used. 5. The common dividend payout ratio is 65%. 6. Interest rate on all debt in all recapitalizations is assumed to be 16% before tax. a 7. Interest foregone on excess cash is assumed to be at a rate of 16% before tax, so with recapitalization, EBIT falls by. 16 times excess cash of $233 million or $37.3 million. Thus, pro forma EBIT is $917.5 million (actual EBIT of $954.8 million minus $37.3 reduction in interest from excess cash). 8. Details of Recapitalizations (millions of dollars): Excess cash Additional debt Total repurchase Reduction in common shares outstanding (million shares) 30% Debt Ratio 233 400.6 633.6 50% Debt Ratio 233 669.4 902.4 70% Debt Ratio 233 938.2 1171.2 19.8 28.2 36.6 Examine the variability of GKG's operating profit: For the period 1972 - 1981, determine the firm's operating profit margin (OPM - Operating Income Sales) for each year assuming a tax rate of 45%. To convert net income to operating profit assume that historically the interest rate on all debt for GKG was 16% and that GKG earned the same 16% on all cash. (Note this was a period of very high interest rates!). Our goal is to estimate how much debt the operations of the firm can support (Net Debt), so make sure to exclude all non-operating income 8. Are yearly OPMs stable or volatile? Is OPM very different than the average during the recessions of 1974- 75 and 1980-81? c What was the lowest OPM that GKG realized during the last 10 years? a 2 Examine how large GKG's potential costs of financial distress. To do so, assess how vulnerable GKG is to having its value reduced by being in financial distress due to the following factors. Use information from the case to provide one or two sentence answers to these questions: Does GKG rely on a specialized work force that may leave the firm if it was in distress? If so, would these workers be hard to replace? 3. Does GKG rely on specialized suppliers that may cease producing custom inputs if GKG were in distress? If so, would these inputs be costly to replace? Does GKG depend on a dealer network to sell its product? Are these dealers likely to switch to selling other products if GKG was close to distress? Would these dealers be costly to replace? Do GKG customers expect continuing support? Is it likely that customers would switch to another product if they thought that GKG was close to distress (1.c. anticipating that GKG would possibly be less likely to provide support in the future)? Is it likely that GKG is vulnerable to competitive attack if it were in financial distress? Are there other firms who have a strong incentive to compete aggressively (eg. lower prices, increase advertising etc.) in an attempt to exacerbate distress at GKG and hopefully push it out of the market? Does GKG need access to the capital markets to fund