July 16, 2019 Duygu Nazlibilek Assignment 1: Williams, 2002 Case FIN 565 | Corporate Financial Strategies 1. What is the rate of return to BH on this deal, and how is it calculated? Thorough evaluation of the terms and lending scenario reveals this loan would create a beneficial scenario not just for the lenders, but for the borrower as well. For Williams, the loan provided temporary relief from multiple short-term debt security maturations and enhanced the company's ability to secure a credit facility of $700 million. This would likely be followed by favorable market reactions in the form of increased stock price as a result sh is ar stu ed d vi y re aC s o ou urc rs e eH w er as o. co m of decreased uncertainty of future cash flows. Also, any BH investments in Williams would signal a strong endorsement of the company's future prospects, likely leading to increases in Williams' stock price. Likewise, for Berkshire Hathaway and Lehman Brothers, this deal should supply high returns on investment. Assuming the loan would be held to maturity, the lenders would divide returns of approximately 34% on this loan. Given that Williams guaranteed the loan, backing it with asset and capital stock, such returns on this risk would be a huge win for both lenders. Although the risk-free rate would be necessary to determine the exact net present value of the investment opportunity facing Berkshire Hathaway and Lehman Brothers, sufficient information is available to find the project's internal rate of return. The IRR for this agreement is 11.88%. The return on investment (ROI) for this particular agreement ranges between 52% and 58%. In either case, the numbers range because of provision (c) listed in the case's Exhibit 1. The \"deferred setup fee\" fluctuates depending on potential sales of RMT's assets. Period 5 years Principal payment $900M Th Interest rate: 5.8%/year = $52.20/year Additional Interest rate: 14%/year= $126/year Deferred setup fee: 15% = $135 Loan IRR (per quarter) =11.88% IRR = NPV = =1 (1+)^ https://www.coursehero.com/file/44316039/Assignment-1-DNazlibilekpdf/ 0 = 0 IRR=11.88% 1 2. What are some of the principal terms of the deal and what's the effect of those terms on the risks faced by BH? Lenders need to make sure that Williams will be able to pay its interest expense, fees, as well as principal at maturity. Therefore, the agreement imposed a minimum of interest coverage ratio and fixed charge coverage ratio. Williams needs to improve its business operation as well as maintain its financing expenses in order to keep the value of the investment. It is important for the lenders that Williams maintains the value of the investment; therefore, lenders should have the right to attend board of directors meeting. Another purpose is to prevent agency problems that might arise between the management, shareholders and lenders. In addition, the required sh is ar stu ed d vi y re aC s o ou urc rs e eH w er as o. co m limit of restricted payments as well as capital expenditures has a purpose of limiting Williams' capital outflow. Guarantees: Those involved in the lending process establish financing terms to protect the positions of all parties. The debt guarantee in Williams' proposed financing, for example, provided insurance for the repayment of debt. Williams would essentially act as a co-signer for Williams Production RMT's obligations to Berkshire Hathaway and Lehman Brothers. Per the terms, Williams would have to agree to make payments in place of Williams Production RMT if any of the payments were late or not paid. Using a guarantor would allow Williams Production RMT access to a loan at a lower interest rate than if Williams had not secured the loan. The logic behind this is that two individuals or entities promising to pay back the debt means there is lessened risk for overall default. That means Berkshire and Lehman may be willing to accept a lower interest rate in return for less risk of loss. It is quite possible that Williams Production RMT would not have been able to obtain a loan without a guarantee. Covenants: Equity and debt investors have a somewhat adversarial position, though both want a company to succeed. Equity investors want the company to take a certain amount of risk, so they have the chance of seeing Th large returns. Debt investors want a company to be more conservative to protect the issuer and to ensure that the company will repay its debts. Like many other companies, Williams' top priority, however, is to maximize stockholder wealth. This creates a dilemma in a debt offering. Berkshire Hathaway and Lehman Brothers therefore use debt covenants to limit the amount of risk Williams can take in the hopes that the company's actions will not endanger loan repayment. https://www.coursehero.com/file/44316039/Assignment-1-DNazlibilekpdf/ 2 Collectively, these covenants outline the rights of the lenders and restrictions upon Williams in regard to the loan. When a company does not live up to its debt covenant, it breaches the contract. In theory, such action would trigger automatic payment to creditors. In reality, however, many companies default because they are not in good financial health and thus cannot pay. Therefore, breach of covenant usually means that the two parties renegotiate the terms of the debt, often calling for higher interest rates or other incentives for the issuer to allow Williams more time to pay. 3. How does the overall return to BH look relative to the risks? The return to investors for this loan is 4% interest, 14% of additional payment paid in maturity, and the deferred sh is ar stu ed d vi y re aC s o ou urc rs e eH w er as o. co m setup fee of 15% if RMT does not sell its assets. The rate of the deferred fee ranges from 15% to 21%, depending on whether RMT sells its assets and if they receive gain or loss from the sale. 4. How much money does Williams need? And, how did Williams get into this situation? During the first half of 2002, Williams suffered a number of financial difficulties. The company's total cash flow decreased by 680.22 percent as compared with 2001. During the year, Williams' only net positive cash inflows came from financing, which netted the company $1.061 billion. In contrast to cash inflows, the company's outflows totaled $1.589 billion from operations and investing. Overall, the decrease can largely be attributed to the decrease in cash flow from operations, which amounted to a decrease of $2.566 billion. Specific to operations, much to blame is the company's decrease in working capital of $879 million To adjust for this decrease in cash flows, the company liquidated a number of assets in 2002. The most valuable included the Kern River and Williams pipelines, which generated immediate cash proceeds of $1.124 billion. The Th question remained, however, as to how Williams would be able to find a way to pay debts of $2.347 billion within the next year and eventually long-term debts of $11.972 billion. In May 2002, the firm sold another $1.7 billion in assets and announced its intention to sell an $1.5 to $3 billion in assets. Previously, in December 2001, Williams planned to cut its 2002 capital spending by 25 percent or $1 billion to bolster its balance sheet. https://www.coursehero.com/file/44316039/Assignment-1-DNazlibilekpdf/ 3 Williams also issued $1 billion in equity-linked securities called FELINE PACS and decided to cut its dividend by 95 percent. While seemingly drastic measures, the negative total cash flow of $619 million reveals that reducing dividend payments and selling off two major sources of operating income was not sufficient for Williams to dig itself out from under its debt obligations without independent financial assistance. It was clear that Williams was in deep. Though the signs of distress were many, the most noticeable was that the company's cash flows were insufficient to meet its short-term debt. Unless the company continued to take drastic action, it could have found itself entering into bankruptcy proceedings within the next year. sh is ar stu ed d vi y re aC s o ou urc rs e eH w er as o. co m Another concerning sign included that in 2002, Williams' 95 percent decrease in dividend payments and its more than 90 percent decrease in stock price should have indicated that the firm was struggling. Particularly striking was the fact that dividend disbursements had been increasing for the prior 10 years and that Williams Communications stock closed at a mere $0.01 per share on July 31, 2002. Williams also sent strongly negative signals with its 2002 sales of its Kern River and Williams pipelines. Although these netted the company immediate cash amounting to $1.124 billion, the sale was made at the sacrifice of substantial cash inflows, suggesting this was an act of desperation. Investors weren't the only ones receiving signs of Williams' distress. Credit agencies also observed uncertainty in Williams' future, as indicated by the company's fluctuating credit ratings. With Williams in July 2002 settling at a B+ Standard & Poor's long-term credit rating, the company saw resulting increases in bond yields. Whereas Williams had bond yields of approximately 7 percent in December 2001, its yields fell just under 20 percent in July Th 2002, further complicating its situation. 5. Why should BH want to invest in Williams? Williams' plight left it with few options for restoring its financial solvency, and most were of limited feasibility. Williams could have issued additional equity at the then current stock price of $2.95 per share, though this would dilute the company's current share base. In addition, most companies only hold seasoned equity offerings when they believe their stock is overpriced. Considering that Williams' stock price had fallen by more than 90%, Williams should not consider an equity offering. https://www.coursehero.com/file/44316039/Assignment-1-DNazlibilekpdf/ 4 The company also could have issued more bonds. This option was not feasible, however, due to the company's credit downgrade. With Standard & Poor's rating the company a B+ in July 2002, Williams would have to issue many bonds and pay a substantial yield amounting to just under 20 percent per annuum. Williams also could have sold assets. Since Williams had already sold close to $3.0 billion in assets, however, selling more could damage the company's ability to generate operating cash flows. Though Berkshire and Lehman presented an opportunity, most lenders were hesitant to provide Williams capital due to the company's financial turmoil. This large, 35 percent interest loan appears to have the most favorable terms possible for Williams in its last-ditch effort to save itself. The real winner here, however, would be Berkshire sh is ar stu ed d vi y re aC s o ou urc rs e eH w er as o. co m Hathaway and Lehman Brothers, both of whom would glean a lucrative return on their investment, given it is Th successful. Williams, on the other hand, should agree to the loan only because it has no other feasible options. https://www.coursehero.com/file/44316039/Assignment-1-DNazlibilekpdf/ Powered by TCPDF (www.tcpdf.org) 5