ASPEON SPARKLING WATER, INC.

Aspeon Sparkling Water, Inc., bottles pure Rocky Mountain spring water and sells it through independent distributors located throughout the continental United States. The company owns and operates regional warehouses in St. Louis, Buffalo, Jacksonville, and Los Angeles. Basically, Aspeon sells its water to wholesale distributors who have exclusive rights to a given territory. Then, the distributors sell it to supermarkets within their region. Additionally, Aspeon is responsible for marketing the product nationally. The company was founded in 1981 by Beth Poe, then a recent graduate of the University of Michigan. Beth grew up in Aspen, Colorado. She knew that consumers were becoming more health conscious, and she recognized a demand for clean, fresh-tasting water. After returning to Colorado upon graduation and convincing her wealthy parents to become silent partners, she obtained the necessary equity capital to build a plant. Aspeon grew rapidly from its initial customer base in Colorado, and by 1988 Aspeon water was on virtually every supermarket shelf in America. Beth was a dedicated believer in the virtues of equity nancing. Although the company had used debt nancing in the early years to nance the regional warehouses, Beth always used Aspeon's cash ows to retire the debt as soon as possible. Beth believes that the market for her company's product has nally matured. First, numerous bottled-water companies, such as Zephyrhills and Evian, have appeared on the scene. Second, it is extremely difcult to differentiate Aspeon from other brands of water. Third, the product is currently sold throughout the country, and there are no additional markets to enter. Thus, Beth expects Aspeon's 1993 earnings before interest and taxes (EBIT) of $32 million to remain relatively constant into the foreseeable future. Aspeon has 10 million shares of common stock outstanding, which is traded in the over-thecounter market. The current stock price is $12.00, so the total value of Aspeon's equity is $120 million. The book value of the rm's stock is also $120 million, so the stock now sells at its book value. Beth owns 20 percent of the outstanding shares, and others in the management group own an additional 10 percent. The company's nancial manager, Emily Martin, has been preaching for years that Aspeon should use debt in its capital structure. "After all," says Emily, "everybody else is using at least some debt, and many firms use a great deal of debt financing. I don't want to put the rm into the junk bond categorythat market has been hammered over the past few years-but I do think that the judicious use of debt can benefit everyone. Also, by being unleveraged, we are just inviting some raider to line up a lot of debt financing and then make a run at our company." Beth's reaction to Emily's prodding was cautious. However, since one of Beth's friends just lost his unleveraged company to a raider, she was willing to give Emily a chance to prove her point.

Emily had worked with Beth for the past six years, and she knew that the only way she could convince Beth that the rm should use debt nancing would be to conduct a comprehensive quantitative analysis. To begin, Emily arranged for a joint meeting with her former finance professor and an investment banker who specializes in corporate financing for consumer products companies. After several hours, the trio agreed on these estimates for the relationships between the amount of debt nancing and Aspeon's capital costs:

Amount Borrowed (in Millions of Dollars) Cost of Debt Cost of Equity $0.0 0.0% 16.0% 25.0 10.0 16.5 50.0 11.0 17.5 75.5 13.0 19.0 100.0 16.0 21.0 125.0 20.0 26.0

If Aspeon recapitalizes, the borrowed funds would be used to repurchase the rm's stock in the over-the-counter market. The rm's federal-plus-state tax bracket is 40 percent. The effective personal tax rate on income from stock is 25 percent and on income from debt is 30 percent. Assume that Emily has passed the assignment on to you, her assistant, for answers. She suggests that the presentation to Beth begin by discussing various types of risk, how risk is measured, how risk affects capital structure decisions, and how the analysis would change if Aspeon's business risk were signicantly higher or lower than originally estimated. As a starting point to finding the optimal capital structure, Emily suggests calculating Aspeon's stock price, number of shares remaining after recapitalization, EPS, and WACC at each debt level. Beth previously indicated that she did not completely understand the relationships between the amount of debt, EPS, stock price, and WACC. Beth discussed the rm's situation with various friends of hers who are nancial analysts. Each has given Beth advice on what factors to consider in the analysis. Beth highly regards her friends' expertise and forwards their comments to Emily to consider in the analysis. For example, Henry Rathbone, a financial analyst in the bottled-water industry, believes that although Aspeon's EBIT is expected to be $32 million, there is a great deal of uncertainty in the estimate. He formulated the following probability distribution:

Probability EBIT

0.25 $10,000,000 0.50 32,000,000 0.25 54,000,000

Henry suggests conducting an ROE and TIE analysis at each EBIT level under two capitalization alternatives: all equity capital structure with $120 million of stock, or $60 million of 13 percent debt plus $60 million of equity. Jenny Lippincott, another of Beth's friends who is aware of her aversion to debt financing, informs her that the new debt could be added in phases instead of all at once. Thus, assuming that Aspeon recapitalized with $25 million of debt (hence S = $107,272,727, D = $25,000,000, V = $132,272,727, P = $13.23, and n = 8,109,966), Jenny proposes two future alternatives: Aspeon could increase its debt to $50 million by issuing $50 million of new debt and using half to refund the existing issue and half to repurchase stock, or it could issue $25 million of new debt without refunding the rst issue. Emily would like each proposal evaluated to ascertain its impact on stock price.

Beth also sought advice concerning Aspeon's capital structure from Jean Claude Van Lamb, her college finance professor. Professor Van Lamb scolded Beth for not remembering two capital structure theories taught in class: the Modigliani-Miller with corporate taxes and the Miller model. For simplicity's sake, he suggested using $120 million as the value of the unlevered firm in both models when calculating Aspeon's value. Beth wants both models used to determine Aspeon's value at $75 million of debt. She is also unsure why the three models (MM, Miller, and the EBIT/capital cost model), all of which are designed to calculate value, yield different results. Beth is often skeptical of financial theories. Therefore, Emily recommends addressing the weaknesses of the analysis as well as other approaches that could be used to determine an appropriate target capital structure for Aspeon. Emily has a strong finance background, and Beth is an excellent businesswoman with good instincts. Be sure to be prepared for follow-up questions.

QUESTIONS

Consider what would happen if Aspeon's business risk were considerably different than that used to estimate the nancial leverage/capital cost relationships given in the case.

a. Describe how the analysis would change if Aspeon's business risk were signicantly higher than originally estimated. If you are using the Lotus model for this case, assume that the following set of leverage/cost estimates applies:using the Lotus model for this case, assume that the following set of leverage/cost estimates applies:

Amount Borrowed (in Millions of Dollars) Cost of Debt Cost of Equity $0.0 0.0% 17.0% 25.0 11.0 18.0 50.0 13.0 20.0 75.5 16.0 23.0 100.0 20.0 27.0 125.0 25.0 32.0

What would be Aspeon's optimal capital structure in this situation?

b. How would things change if the rm's business risk were considerably lower than originally estimated?If you are using the Lotus model for this case, assume that the following set of leverage/cost estimates applies:

Amount Borrowed (in Millions of Dollars) Cost of Debt Cost of Equity $0.0 0.0% 14.0% 25.0 8.0 14.3 50.0 8.5 15.0 75.0 9.5 16.0 100.0 11.5 17.5 125.0 13.5 19.0

What would be the rm's optimal capital structure in this situation?