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Capital Structure Policy 10 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 financing. Although the company had used debt financing in the early years to finance the regional warehouses, Beth always used Aspeon's cash flows to retire the debt as soon as possible. Beth believes that the market for her company's product has finally matured. First, numerous bottled-water companies, such as Zephyrhills and Evian, have appeared on the scene. Second, it is extremely difficult 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 firm'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 financial 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 firm 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. Copyright 1994. The Dryden Press. All rights reserved. Case: 10 Capital Structure Policy Emily had worked with Beth for the past six years, and she knew that the only way she could convince Beth that the firm should use debt financing 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 financing and Aspeon's capital costs: Amount Borrowed (in Millions of Dollars) Cost of Debt $ 0.0 0.0% 25.0 10.0 50.0 11.0 75.5 13.0 100.0 16.0 125.0 20.0 Cost of Equity 16.0% 16.5 17.5 19.0 21.0 26.0 If Aspeon recapitalizes, the borrowed funds would be used to repurchase the firm's stock in the over-the-counter market. The firm'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. With these data in hand, Emily must now complete an analysis designed to convince Beth to use some debt financing. 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 significantly 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 firm's situation with various friends of hers who are financial 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 0.25 0.50 0.25 EBIT $10,000,000 32,000,000 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 first issue. Emily would like each proposal evaluated to ascertain its impact on stock price. Case: 10 Capital Structure Policy 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 1. a. b. c. d. What is the difference between business risk and financial risk? How can these risks be measured in a total risk sense? How can these risks be measured in a market risk framework? How does business risk affect capital structure decisions? 2. Although Aspeon's EBIT is expected to be $32 million, there is a great deal of uncertainty in the estimate, as indicated by the following probability distribution: Probability 0.25 0.50 0.25 EBIT $10,000,000 32,000,000 54,000,000 Assume that Aspeon had only two capitalization alternatives: Either an all-equity capital structure with $120 million of stock or $60 million of 13 percent debt plus $60 million of equity. a. Conduct a ROE and TIE analysis. That is, construct partial income statements for each financing alternative at each EBIT level. (Hint: Use the upper half of Table 1 as a guide.) b. Now calculate the return on equity (ROE) and times-interest-earned (TIE) ratio for each alternative at each EBIT level. c. Finally, discuss the risk/return tradeoffs under the two financing alternatives. In your discussion, consider the expected ROE and the standard deviation of ROE under each alternative. 3. Since Aspeon is not expected to grow, Emily believes that the following equations can be used in the valuation analysis: (1) S = [EBIT - kd (D)] (1 - T) / ks (2) V = S+D (3) P = (V - D0) / n0 (4) n1 = n0 - D / P Case: 10 Capital Structure Policy (5) VL = VU + TD (Modigliani-Miller) (6) VL = VU + [1 - (1 - Tc) (1 - Ts) / (1 - Td)] D (Miller) Here, S = market value of equity D = value of debt EBIT = earnings before interest and taxes kd = cost of debt D = market (and book) value of new debt D0 = market value of old debt T = tax rate Tc = corporate tax rate Ts = tax rate on income from stock Td = tax rate on income from debt ks = cost of equity V = total market value P = stock price after recapitalization n0 = number of shares before recapitalization n1 = number of shares after recapitalization a. Explain the logic of Equation (1) for a zero-growth firm. b. Describe briefly, without using numbers, the sequence of events that would occur if Aspeon decided to recapitalize. 4. Now, use the data given in the case as the basis for a valuation analysis. a. Estimate Aspeon's stock price at the six levels of debt given in the case. (Hint: Use the lower half of Table 1 as a guide. Assume that all debt issued by the firm is perpetual.) b. How many shares would remain after recapitalization under each debt scenario? c. Considering only the six levels of debt proposed in the case, what is Aspeon's optimal capital structure? 5. Now assume that Aspeon recapitalized with $25.0 million of debt, hence S = $107,272,727; D = $25,000,000; V = $132,272,727; P = $13.23; and n = 8,109,966. Case: 10 Capital Structure Policy a. What would Aspeon's share price and ending number of shares be if it increased its debt to $50 million by issuing $50.0 million of new debt and using half to refund the existing issue and half to repurchase stock? (Assume that the indenture for the first $25.0 million debt issue prohibits the firm from issuing additional debt without refunding.) b. Now assume that Aspeon issues $25.0 million of new debt without refunding the first issue. What would be the stock price and ending number of shares in this situation? (Assume that the old and the new debt issues have the same priority of claims. Also, remember that if the firm has $50 million of debt in total, its cost of debt is 11 percent, so the new $25.0 million debt issue will have an interest rate of 11 percent, and the old debt issue will have a required rate of return of 11 percent.) c. Explain why the prices are higher in Parts a and b than those obtained in Question 4. 6. In addition to valuation estimates, most managers are also concerned with the impact of financial leverage on the firm's earnings per share (EPS) and weighted average cost of capital (WACC). a. Calculate the EPS at each debt level, assuming that Aspeon begins with zero debt and raises new debt in a single issue. b. Is EPS maximized at the same debt level that maximizes stock price? c. Calculate the WACC at each debt level. d. What are the relationships between the amount of debt, stock price, and WACC? 7. Consider what would happen if Aspeon's business risk were considerably different than that used to estimate the financial leverage/capital cost relationships given in the case. a. Describe how the analysis would change if Aspeon's business risk were significantly 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 $ 0.0 0.0% 25.0 11.0 50.0 13.0 75.5 16.0 100.0 20.0 125.0 25.0 Cost of Equity 17.0% 18.0 20.0 23.0 27.0 32.0 What would be Aspeon's optimal capital structure in this situation? b. How would things change if the firm'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 $ 0.0 0.0% 25.0 8.0 50.0 8.5 75.0 9.5 100.0 11.5 125.0 13.5 Cost of Equity 14.0% 14.3 15.0 16.0 17.5 19.0 Case: 10 Capital Structure Policy What would be the firm's optimal capital structure in this situation? 8. Now consider two capital structure theories: Modigliani-Miller with corporate taxes (MM63) and the Miller model. a. What would Aspeon's value at $75.0 million of debt be, according to the MM63 model? b. What would the firm's value be, according to the Miller model? (Assume that the personal tax rate on income from stock [Ts] is 25 percent, and the personal tax rate on income from debt [Td] is 30 percent. Also, use $120 million as the value of the unlevered firm [VU] in both the MM63 and Miller models, even though it should be less in the Miller model.) c. Why do the values differ when calculated by the equations in Question 3, the MM63 model, and the Miller model? (Hint: Consider the assumptions that underlie each model.) 9. How do control issues affect the capital structure decision? 10. Consider the usefulness of this analysis for most firms. a. What are the major weaknesses of the type of analysis called for in the case? b. What other approaches could managers use to help determine an appropriate target capital structure? c. Is the target capital structure best thought of as a point estimate or as a range? d. What other factors should managers consider when setting their firms' target capital structures? TABLE 1 Selected Case Data ROE and TIE Analyses: Probability EBIT Interest EBT Taxes Net Income ROE TIE E(ROE) ROE CV 0.25 $10,000,000 0 $10,000,000 4,000,000 X 5.0% n.a. Valuation Analysis: D (000s) S $ 0 $120,000,000 25,000 107,272,727 X X X X 100,000 45,714,286 125,000 16,153,846 All Equity 0.50 $32,000,000 0 X X $19,200,000 0.25 $54,000,000 0 X X $32,400,000 X n.a 16.0% 7.8% 0.49 V $120,000,000 132,272,727 X X 145,714,286 141,153,846 27.0% n.a D/V 0% 19 X X 69 89 50% Debt 0.50 $32,000,000 7,800,000 $24,200,000 9,680,000 $14,520,000 0.25 $10,000,000 7,800,000 $ 2,200,000 880,000 $ 1,320,000 2.2% 1.28 P $12.00 13.23 X X 14.57 14.12 WACC 16.0% 14.5 X X 13.2 13.6 24.2% 4.10 X 15.6% 0.64 Number of Shares 10,000,000 8,109,966 X X 3,137,255 1,144,414 0.25 $54,000,000 7,800,000 $46,200,000 18,480,000 $27,720,000 X X EPS $1.92 2.18 X X 3.06 3.67