Kleen Kar, Inc. Capital Structure. Here is attached the topic. I would like to get the answers of the 6 first questions

Capital Structure Policy 9 sh is ar stu ed d vi y re aC s ou ou rc rs e eH w er as o. co m KLEEN KAR, INC. Th Kleen Kar, Inc., franchises automobile care centers throughout the southern United States. A complete Kleen Kar center includes a building with an automatic car washing bay and four service bays. The company also offers 10-minute oil changes and wax jobs for $15.95 each. Basically, the franchisee buys the exclusive right to use the Kleen Kar name within a given territory. In addition, franchisees receive marketing and management support and have access to low-cost supplies such as soap, wax, and oil. Todd Lyle, a Louisiana State University graduate who founded the company in 1981, recognized the need for a fast and convenient automobile car care center. Customers of Kleen Kar could receive an oil change, wash, and wax in less than 30 minutes. Kleen Kar expanded rapidly from its base in New Orleans, first by opening company-owned stores in large cities in the South such as Miami, Orlando, Atlanta, and New Orleans, and then by franchising into other southern cities and towns. Todd was a firm believer in the virtues of equity financing. Although the company had used debt nancing in the early years to nance the company-owned store expansion, Todd always used Kleen Kar's cash flows to retire the debt as soon as possible. Recent growth has occurred from franchising, where the franchisee puts up the required capital. Thus, the company has not required outside capital in several years. Todd believes that the market for his company's services has nally matured. First, numerous competing chains, such as the Mad Hatter, $12.95 Handwax, and Oil Can Henry's, have appeared on the scene, and it now seems as if every town in the country with a population over 10,000 has at least one fast-food and one car care center franchise. Second, self-service gas stations, such as Mobil and British Petroleum, offer free automatic car washes with the purchase of gasoline. Third, many large oil companies, such as Pennzoil and Shell Oil, are entering the oil-change market and offering even lower prices in order to gain market share. Thus, Todd expects Kleen Kar's 1993 earnings before interest and taxes (EBIT) of $17 million to remain relatively constant into the foreseeable future. Kleen Kar has 10 million shares of common stock outstanding, which is traded in the over-thecounter market. The current stock price is $6, so the total value of Kleen Kar's equity is $60 million. The book value of the firm's stock is also $60 million, so the stock now sells at its book value. Todd owns 20 percent of the outstanding shares, and others in the management group collectively own an additional 10 percent. The company's financial manager, Bill Joseph, has been preaching for years that Kleen Kar should use debt in its capital structure. \"After all,\" says Bill, \"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 Copyright 1994. The Dryden Press. All rights reserved. https://www.coursehero.com/file/5665058/case303/ Case: 09 Capital Structure Policy think that judicious use of debt can benefit everyone. Also, by being unleveraged, we are just inviting some raider to line up a lot of debt nancing and then make a run at our company.\" Todd's reaction to Bill's prodding was cautious. However, since one of Todd's friends just lost her unleveraged company to a raider, he was willing to give Bill a chance to prove his point. Bill had worked with Todd for the past six years, and he knew that the only way he could ever convince Todd that the firm should use debt financing would be to conduct a comprehensive quantitative analysis. To begin, Bill arranged for a joint meeting with his former nance professor and an investment banker who specializes in corporate nancing for service companies. After several hours, the trio agreed on these estimates for the relationships between the amount of debt nancing and Kleen Kar's capital costs: Cost of Equity 17.0% 17.5 18.5 20.0 22.0 27.0 sh is ar stu ed d vi y re aC s ou ou rc rs e eH w er as o. co m Amount Borrowed (in Millions of Dollars) Cost of Debt $ 0.0 0.0% 12.5 12.0 25.0 13.0 37.5 15.0 50.0 18.0 62.5 22.0 If Kleen Kar 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. With these data at hand, Bill must now complete an analysis designed to convince Todd to use some debt financing. The analysis is going to be presented in question-and-answer format, because Todd seems partial to this approach for conveying ideas. Thus, Bill's first task was to develop the set of questions to be answered. Assume that Bill has passed the questions on to you, his assistant, for answers. Remember that Bill has a strong nance background, and Todd is an excellent businessman with good instincts. Be sure to answer the questions thoroughly and be prepared for follow-up questions. QUESTIONS Th 1. a. b. c. d. What is the difference between business risk and nancial 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 Kleen Kar's EBIT is expected to be $17 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 $ 5,000,000 17,000,000 29,000,000 Assume that Kleen Kar has only two capitalization alternatives: Either an all-equity capital structure with $60 million of stock or $30 million of 14 percent debt plus $30 million of equity. https://www.coursehero.com/file/5665058/case303/ Case: 09 Capital Structure Policy a. Conduct a ROE and TIE analysis. That is, construct partial income statements for each nancing 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 nancing alternatives. In your discussion, consider the expected ROE and the standard deviation of ROE under each alternative. 3. Since Kleen Kar is not expected to grow, Bill believes that the following equations can be used in the valuation analysis: S = [EBIT - kd(D)](1 - T)/ks. (2) V = S + D. (3) (4) Here, S EBIT kd D D0 T ks V P = (V - D0)0. n1 = n0 - D/P. = market value of equity = earnings before interest and taxes = cost of debt = market (and book) value of new debt = market value of old debt = tax rate = cost of equity = total market value = stock price after recapitalization Th P sh is ar stu ed d vi y re aC s ou ou rc rs e eH w er as o. co m (1) n0 n1 = number of shares before recapitalization = number of shares after recapitalization a. Explain the logic of Equation (1) for a zero-growth rm. b. Describe briey, without using numbers, the sequence of events that would occur if Kleen Kar decided to recapitalize. 4. Now, use the data given in the case as the basis for a valuation analysis. a. Estimate Kleen Kar'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 rm is perpetual.) https://www.coursehero.com/file/5665058/case303/ Case: 09 Capital Structure Policy 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 Kleen Kar's optimal capital structure? sh is ar stu ed d vi y re aC s ou ou rc rs e eH w er as o. co m 5. Now assume that Kleen Kar recapitalized with $12.5 million of debt, hence S = $53,142,857; D = $12,500,000; V = $65,642,857; P = $6.56; and n = 8,095,756. a. What would Kleen Kar's share price and ending number of shares be if it increased its debt to $25 million by issuing $25 million of new debt and using half to refund the existing issue and half to repurchase stock? (Assume that the indenture for the rst $12.5 million debt issue prohibits the rm from issuing additional debt without refunding.) b. Now assume that Kleen Kar issues $12.5 million of new debt without refunding the rst 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 rm has $25 million of debt in total, its cost of debt is 13 percent, so the new $12.5 million debt issue will have an interest rate of 13 percent, and the old debt issue will have a required rate of return of 13 percent.) c. Explain why the prices are higher in Parts a and b than those obtained in Question 4. Th 6. In addition to valuation estimates, most managers are also concerned with the impact of nancial leverage on the rm's earnings per share (EPS) and weighted average cost of capital (WACC). a. Calculate the EPS at each debt level, assuming that Kleen Kar 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 Kleen Kar'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 Kleen Kar'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: Amount Borrowed (in Millions of Dollars) Cost of Debt Cost of Equity $0.0 0.0% 18.0% 12.5 13.0% 19.0% 25.0 15.0% 21.0% 37.5 18.0% 24.0% 50.0 22.0% 28.0% 62.5 27.0% 33.0% What would be Kleen Kar'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: https://www.coursehero.com/file/5665058/case303/ Case: 09 Capital Structure Policy Amount Borrowed (in Millions of Dollars) Cost of Debt $ 0.0 0.0% 12.5 10.0% 25.0 10.5% 37.5 11.5% 50.0 13.5% 62.5 15.5% Cost of Equity 15.0% 15.3% 16.0% 17.0% 18.5% 20.0% What would be the rm's optimal capital structure in this situation? sh is ar stu ed d vi y re aC s ou ou rc rs e eH w er as o. co m 8. Now consider two capital structure theories: Modigliani-Miller with corporate taxes (MM63) and the Miller model. a. What would Kleen Kar's value at $37.5 million of debt be, according to the MM63 model? b. What would the rm'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 $60 million as the value of the unlevered rm [VU] in both the MM 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? Th 10. Consider the usefulness of this analysis for most rms. 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 rms' target capital structures? https://www.coursehero.com/file/5665058/case303/ vi a Selected Case Data ROE and TIE Analyses: 5.0% n.a. S $60,000,000 53,142,857 X X 21,818,182 7,222,222 Th Valuation Analysis: D (000s) $ 0 12,500 X X 50,000 62,500 https://www.coursehero.com/file/5665058/case303/ Powered by TCPDF (www.tcpdf.org) 0.25 $29,000,000 0 X X $17,400,000 X n.a 17.0% 8.5% 0.50 V $60,000,000 65,642,857 X X 71,818,182 69,722,222 29.0% n.a D/V 0% 19 X X 70 90 50% Debt 0.50 $17,000,000 4,200,000 $12,800,000 5,120,000 $7,680,000 0.25 $5,000,000 4,200,000 $800,000 320,000 $480,000 as s All Equity 0.50 $17,000,000 0 X X $10,200,000 is ou st rs ud eH y er res o. ou co rc m e ROE TIE E(ROE) ROE CV 0.25 $5,000,000 0 $5,000,000 2,000,000 X w Probability EBIT Interest EBT Taxes Net Income ha re d TABLE 1 P $6.00 6.56 X X 7.18 6.97 1.6% 1.19 WACC 17.0% 15.5 X X 14.2 14.6 25.6% 4.05 X 17.0% 0.66 Number of Shares 10,000,000 8,095,756 X X 3,037,975 1,035,857 0.25 $29,000,000 4,200,000 $24,800,000 9.920,000 $14,880,000 X X EPS $1.02 1.15 X X 1.58 1.88