Hargrove, Inc. manufactures industrial valves. Hargrove has expected Sales of 133,674 per year. SG&A and COGS make up about $0.95 of every dollar of Sales in a typical year. Sales growth is expected to be flat. As a result, Hargrove expects CAPEX to be equal to depreciation expense going forward, and they do not expect to any investments in working capital. Hargrove has assets worth about 10,000. Hargrove's firm beta is 4.53. The market risk premium is 5% and the risk free rate is 5%.

Currently, Hargrove, Inc. is financed with 100% equity and has 1,000,000 shares outstanding. Hargrove is considering a 'debt for equity swap'. A debt for equity swap involves a firm issuing debt and using the proceeds to pay a "special dividend" to equity holders. Hargrove's CEO Mike Chaei (pronounced Shy) is extremely excited about the idea. According to Mike,

"We have really entered a mature stage in Hargrove's life cycle. The industry is quite competitive and sales growth is flat. In order to add value for our shareholders we need to find economies anywhere we can. Since discount rates on debt are lower than discount rates on equity, Hargrove can capitalize on the lower debt rates and add value for shareholders by availing ourselves of cheaper capital. If we can't lower our cost of capital, we are at risk of losing to our competition"

Hargove's CFO Karen Fich has told Mike that she thinks that Hargrove could manage a debt load of about 33% of the firm's total capitalization. She has spoken to several banks and received favorable reaction. She estimates from talking to the bankers that the debt will have an interest rate of 11% and a 30 year term. Karen expects that the debt will have a beta of 0.38.

Questions:

Before the Swap: Please address the following questions. Your responses will take the form of an Excel spreadsheet with your calculations and imagines of your schematics.

1. WhatisHargroveworthbeforetheyengageinthedebtforequityswap? 2. WhatisHargrove'sValueadd? 3. WhatisthepricepershareofHargrove'sequity?

4. WhatisHargrove'sequitybeta? 5. WhatisHargrove'scostofequitycapital? 6. WhatisHargrove'sWACC? 7. Pleaseusetheprovidedschematictorecordyouranswerstotheabove.

After the Swap: Please address the following questions. Your responses will take the form of an Excel spreadsheet and imagines of your schematics.

PleaseincludeHargrove'sdebtontheschematicprovided.WhatfractionofHargrove's ticket stack will be comprised of debt after the swap?

How much will the equity holders receive in the special dividend?

10. What will Hargrove's cost of debt be? Please place Hargrove's cost of debt on the schematic.

11. What will Hargrove's beta of equity be? What will their cost of equity be? Please place both the beta of equity and the cost of equity on the schematic.

12. What will Hargrove's firm beta be after the swap? Please the firm beta on the schematic

13. Please use the discount rates of equity and debt to compute Hargrove's WACC after the 'swap'. Please place the WACC on the schematic.

14. What will Hargrove, Inc be worth after the 'swap'?

15.What is the price per share of Hargrove's equity after the swap?

Overall: Please address the following questions. Your responses should be in paragraph form, with no more than one paragraph per question.

16. What do you think of Mike's rationale for undergoing the debt for equity swap at Hargrove? Does the swap increase value or value add at Hargrove? Why or why not?

17. Would Hargrove's WACC change in the way that Mike expected it would? Why or why not?

18. A board member at Hargrove says that this swap will make Hargrove's share price drop. She says that shows it is a bad idea. Would the swap make Hargrove's equity holders better off? Why or why not?

19.Do the equity holders face more or less risk after the swap? Please explain your answer. 20.Do you think that Mike should go forward with the swap? 20.Do you think that Mike should go forward with the swap?