Adam Rust and Jenna Hawthorne were newly hired financial analysts for Readers Digest Association, publisher of the world's bestselling magazine. Their first assignment had been a big one - performing a financial statement analysis of the firm. Reader's Digest had just purchased another magazine publisher, Reiman Industries. The firm had taken on a $950 million loan to pay for the acquisition. However, only $726.3 million of the loan would be used to purchase Reiman. The remainder, $223.7 million, would be used to repurchase shares. Reader's Digest had two classes of shares, non-voting A shares and voting B shares. All of the B shares were to be repurchased or exchanged for A shares, so after the reclassification, Reader's Digest would have only 1 class of shares, A shares, which would all be voting shares. A shares, trading under RDA on the New York Stock Exchange, currently sold for $20.85 a share. The B shares would be repurchased at a premium for $27.78. The shares were purchased at a premium because the represented control. Control has value, and the $27.78 price was negotiated by the B shareholders and the firm. The $950 million loan carried a 6% interest rate and had the following repayment of principal schedule:

Year 1: $132 million

Year 2: $32 million

Year 3: $57 million

Year 4: $82 million

Year 5: $82 million

Year 6: $565 million

With the Reiman acquisition, Reader's Digest was expecting:

Revenues $2,824.4 million

Operating Profit $ 263.1 million

Net Income $ 110.9 million

Total Assets $2,829 million

Book Value Equity $436.3 million

Number of common shares outstanding before repurchase: 102.7 million

Dividend per share: $0.20

Tax rate: 30%

Now Adam and Jenna were asked to evaluate the impact of the loan on Reader's Digest common shareholders. Was any value being created by the loan? Would this impact earnings per share and return on equity for shareholders?

Adam and Jenna were also puzzled by the lawsuits Reader's Digest was also facing. Up until this year, Reader's Digest had two classes of stock, A shares and B shares, both traded on the New York Stock Exchange. However, only B shares had voting privileges. All of the shares had equal claim on the firm's net income and the dividend per share was the same for all shares. Reader's Digest announced that it was reclassifying all of its shares into voting A shares. All B shares would be either bought back by the firm or converted into A shares. Each B share would be converted into 1.24 A shares. After the announcement, Reader's Digest was sued by several A shareholders who said that the proposed recapitalization was unfair to them and also sued by B

shareholders who made the same claim - that the reclassification was unfair to them. Adam and Jenna were both looking at participating in the firm's employee stock purchase plan which would allow them to purchase A shares at a 10% discount to the market price. They didn't understand what impact the reclassification would have on their future A shares and how both A and B shareholders could be unhappy about the reclassification.

1. How could Reader's Digest's market price be impacted by the decision to purchase Reiman? How would Reader's Digest know if this acquisition should be made? How can the company assesses the market's evaluation of its acquisition decision?
2. Does it make sense for Reader's Digest to offer B shareholders more than one A share for every B share that they own? Why might both types of shareholder be unhappy with the reclassification of shares?