Mr. Wilner Talbot Wizner is CEO of National Electronics Corp. (NEC) and has held that position since 2002. Mr. Wizner has never felt comfortable with having debt in the company's capital structure. During the 15 years of his tenure as CEO, NEC has experienced impressive growth in sales, earnings and dividends. The date is now February 2017. At the end of 2016, NEC had essentially no debt on its balance sheet and had cash equal to 25% of its net worth. Mr. Wizner is expected to retire in the near future and Wall Street analysts have the view that NEC will likely adjust its capital structure to include more debt after his departure. The Company NEC's 2016 sales of nearly $4 billion were generated by over 40 brands in four lines of business: entertainment electronics (such as handheld games), cell phones, internal electronics (such as electronics for automobiles), and PDAs. NEC's largest and most profitable business PDAs - has a major market share against well-known competitors. NEC's success has been built on marketing expertise. Whether the product is a game console or a new cell phone, NEC makes a practice of out-marketing" the competition. NEC has a distinctive corporate culture that reflects the personal traits of its CEO. This culture has several features. The company is known for its tight financial controls and frugality. Any expenditure greater than $100,000 must be personally approved by Mr. Wizner, even if it has been previously allocated in the corporate budget. NEC's culture can also be described as highly risk averse. NEC consistently avoids much of the risk of new-product development in the volatile electronics industry. Historically, most of its new products either were acquired or licensed after their development by other firms or they were copies of new products introduced by competitors. Further, many of NEC's new products are modest extensions of existing products. NEC thus avoids taking chances on R&D and new- product introductions and uses its marketing skills to promote purchased products and product extensions. When innovative products are introduced by competitors, NEC responds with similar products and relies on its marketing expertise to catch up with the competition. NEC's Performance Under Mr. Wizner's oversight, NEC has generated impressive financial results. NEC has experienced consistent growth in sales, earnings, and dividends over the past two decades. NEC has used internally generated capital to finance its growth while still maintaining a dividend payout ratio of nearly 60% of earnings. Further, NEC's six-fold growth in earnings per share has been accompanied by a tripling of its stock price. NEC's Capital Structure Policy Many technology firms use relatively little debt financing, but few match NEC's low leverage ratio. Because of NEC's breadth of activities, it is difficult to find a truly similar company for MGMT 61000, Fall 2019 National Electronics Corp. (Abridged II) - 1 comparison. The closest is K Group, Inc. (KGroup) KGroup has a debt-to-total capital ratio of 32% and its bond rating is AAA/AA (see Exhibit 1). The effect of a more aggressive capital structure that is likely to come about with a change in CEO has been evaluated by analysts who follow NEC's stock. Exhibits 1 and 2 show actual 2016 performance and pro-forma statements for 2017 under two capital structures. As presented in Exhibit 3, these projections assume that NEC issues debt and uses the proceeds to repurchase stock at a price of $30 per share. The likely retirement of Mr. Wizner in the near term has generated speculation about a recapitalization and the impact of such a change in policy on the company's stock price and equity market value. Assignment 1. Compare the characteristics of NEC and KGroup in Exhibit 1. What similarities do you see? What differences? Consider cash balances, receivables, inventory, property, plant & equipment, bond ratings, common stock betas, and leverage ratios among other features. Can you draw any inferences from these observations? 2. Suppose NEC uses the proceeds of a debt issue as shown in Exhibit 2 to buy back shares. What will happen to the total market value of common stock when the share repurchase is announced? What will happen to the price per share of stock when the buyback is announced? At what price should the shares be repurchased? How many shares will be repurchased? What will happen to total shareholder wealth? (Hint: Remember that the number of shares repurchased will depend on the repurchase price and the repurchase price will depend on the amount of debt issued.) 3. Now, suppose management decides to undertake a recapitalization by means of a fixed price tender at $35 per share. How many shares will be repurchased? What will happen to stock price when the transaction is announced? What will happen to shareholder wealth? What will happen to shareholder wealth after the transaction is completed? 4. What leverage policy do you recommend? (Consider leverage ratio, coverage ratio, and bond rating.) Should the leverage policy be determined by book values or market values? 5. Assume that the current yield on intermediate term treasury bonds is 5.0% and the market risk premium is 6.2%. What is the firm's weighted average costs of capital under alternative capital structures? What is the company's weighted average cost of capital under your proposed optimal/target capital structure? Exhibit 1 Comparison Data for NEC and KGroup, 2016 ($ in millions except per share and ratio data) NEC KGroup Sales 5-year compound annual growth rate Earnings after tax 5-year compound annual growth rate $ 3,798.5 11.0% $ 445.9 12.2% $ 3,479.2 9.9% $ 192.7 3.3% Cash and equivalents Accounts receivable Inventory Net property, plant and equipment Other assets Total assets Total interest bearing debt Other liabilities Net worth $ 372.0 517.3 557.3 450.5 251.9 2,149.0 13.9 662.3 $ 1,472.8 $360.3 541.5 645.8 827.1 582.5 2,957.2 710.1 764.4 $1,482.7 Earnings per share 5-year compound annual growth rate Dividends per share 5-year compound annual growth rate Stock price (end of 2016) Price/earnings ratio $ 2.84 12.4% $ 1.70 13.6% $ 30.00 10.6 $ 2.41 3.0% $ 1.32 8.0% $ 20.00 8.3 Beta Profit margin Return on equity Interest coverage ratio Ratio of total debt to total capital Bond rating 1.10 11.7% 30.3% 695.4X 0.9% AAA 1.67 5.5% 13.0% 6.9X 32.4% AAAAA a Other liabilities include trade credit (i.e., accounts payable), accrued taxes and other miscellaneous non interest bearing liabilities. b Debt-to-total capital is calculated as interest bearing debt divided by interest bearing debt plus net worth. Moody's rates the KGroup debt as AAA and S&P rates KGroup debt as AA. Exhibit 2 Pro Forma 2017 Results Under Alternative Capital Structures ($ in millions except per share data)* Pro Forma 2017 for Status quo Projected 20171 30% Debt to Total Capital $4,131.2 $4,131.2 799.6 799.6 Sales Earnings before interest, taxes & depreciation Earnings before interest and taxes Interest expense Earnings before taxes 754.6 754.6 1.1 753.5 31.2 723.4 Taxes3 256.2 497.3 0.4 246.0 477.4 0.4 496.9 477.0 Earnings after taxes Dividends on preferred stock Earnings available to common shareholders Dividends on common stock 4 Average common shares outstanding (millions)5 $ 295.3 $ 286.2 155.5 141.1 Earnings per share Dividends per share $ $ 3.20 1.90 $ $ 3.38 2.03 Beginning of Year before Re-Capitalization $ 372.0 $ 13.9 $1,472.8 $30 Beginning of Year after Re-Capitalization $ 372.0 $ 446.0 $1,040.7 Cash and equivalents Total interest paying debt Net worth (book value) Common stock price Total market value of common stock $4,665.0 * See footnotes on following page for explanations. Exhibit 3 Detailed Assumptions for Pro Forma Recapitalizations Presented in Exhibit 2 30% Debt ratio $432.1 Additional Debt (millions) Reduction in common shares outstanding (millions of shares) 14.4 1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase common stock. All repurchases are assumed to be executed in February 2017. The "status quo" pro forma capital structure assumes that NEC will begin in 2017 with its 2016 capital structure strategy unchanged. 2. The interest rate on debt in all recapitalizations is assumed to be 7% before tax. 3. A tax rate of 34% is used. 4. The dividend payout ratio is 60%. 5. Stock is assumed to be repurchased at a price of $30 per share, which was the prevailing stock price in February 2017. 6. Details of recapitalization are in $ millions. Mr. Wilner Talbot Wizner is CEO of National Electronics Corp. (NEC) and has held that position since 2002. Mr. Wizner has never felt comfortable with having debt in the company's capital structure. During the 15 years of his tenure as CEO, NEC has experienced impressive growth in sales, earnings and dividends. The date is now February 2017. At the end of 2016, NEC had essentially no debt on its balance sheet and had cash equal to 25% of its net worth. Mr. Wizner is expected to retire in the near future and Wall Street analysts have the view that NEC will likely adjust its capital structure to include more debt after his departure. The Company NEC's 2016 sales of nearly $4 billion were generated by over 40 brands in four lines of business: entertainment electronics (such as handheld games), cell phones, internal electronics (such as electronics for automobiles), and PDAs. NEC's largest and most profitable business PDAs - has a major market share against well-known competitors. NEC's success has been built on marketing expertise. Whether the product is a game console or a new cell phone, NEC makes a practice of out-marketing" the competition. NEC has a distinctive corporate culture that reflects the personal traits of its CEO. This culture has several features. The company is known for its tight financial controls and frugality. Any expenditure greater than $100,000 must be personally approved by Mr. Wizner, even if it has been previously allocated in the corporate budget. NEC's culture can also be described as highly risk averse. NEC consistently avoids much of the risk of new-product development in the volatile electronics industry. Historically, most of its new products either were acquired or licensed after their development by other firms or they were copies of new products introduced by competitors. Further, many of NEC's new products are modest extensions of existing products. NEC thus avoids taking chances on R&D and new- product introductions and uses its marketing skills to promote purchased products and product extensions. When innovative products are introduced by competitors, NEC responds with similar products and relies on its marketing expertise to catch up with the competition. NEC's Performance Under Mr. Wizner's oversight, NEC has generated impressive financial results. NEC has experienced consistent growth in sales, earnings, and dividends over the past two decades. NEC has used internally generated capital to finance its growth while still maintaining a dividend payout ratio of nearly 60% of earnings. Further, NEC's six-fold growth in earnings per share has been accompanied by a tripling of its stock price. NEC's Capital Structure Policy Many technology firms use relatively little debt financing, but few match NEC's low leverage ratio. Because of NEC's breadth of activities, it is difficult to find a truly similar company for MGMT 61000, Fall 2019 National Electronics Corp. (Abridged II) - 1 comparison. The closest is K Group, Inc. (KGroup) KGroup has a debt-to-total capital ratio of 32% and its bond rating is AAA/AA (see Exhibit 1). The effect of a more aggressive capital structure that is likely to come about with a change in CEO has been evaluated by analysts who follow NEC's stock. Exhibits 1 and 2 show actual 2016 performance and pro-forma statements for 2017 under two capital structures. As presented in Exhibit 3, these projections assume that NEC issues debt and uses the proceeds to repurchase stock at a price of $30 per share. The likely retirement of Mr. Wizner in the near term has generated speculation about a recapitalization and the impact of such a change in policy on the company's stock price and equity market value. Assignment 1. Compare the characteristics of NEC and KGroup in Exhibit 1. What similarities do you see? What differences? Consider cash balances, receivables, inventory, property, plant & equipment, bond ratings, common stock betas, and leverage ratios among other features. Can you draw any inferences from these observations? 2. Suppose NEC uses the proceeds of a debt issue as shown in Exhibit 2 to buy back shares. What will happen to the total market value of common stock when the share repurchase is announced? What will happen to the price per share of stock when the buyback is announced? At what price should the shares be repurchased? How many shares will be repurchased? What will happen to total shareholder wealth? (Hint: Remember that the number of shares repurchased will depend on the repurchase price and the repurchase price will depend on the amount of debt issued.) 3. Now, suppose management decides to undertake a recapitalization by means of a fixed price tender at $35 per share. How many shares will be repurchased? What will happen to stock price when the transaction is announced? What will happen to shareholder wealth? What will happen to shareholder wealth after the transaction is completed? 4. What leverage policy do you recommend? (Consider leverage ratio, coverage ratio, and bond rating.) Should the leverage policy be determined by book values or market values? 5. Assume that the current yield on intermediate term treasury bonds is 5.0% and the market risk premium is 6.2%. What is the firm's weighted average costs of capital under alternative capital structures? What is the company's weighted average cost of capital under your proposed optimal/target capital structure? Exhibit 1 Comparison Data for NEC and KGroup, 2016 ($ in millions except per share and ratio data) NEC KGroup Sales 5-year compound annual growth rate Earnings after tax 5-year compound annual growth rate $ 3,798.5 11.0% $ 445.9 12.2% $ 3,479.2 9.9% $ 192.7 3.3% Cash and equivalents Accounts receivable Inventory Net property, plant and equipment Other assets Total assets Total interest bearing debt Other liabilities Net worth $ 372.0 517.3 557.3 450.5 251.9 2,149.0 13.9 662.3 $ 1,472.8 $360.3 541.5 645.8 827.1 582.5 2,957.2 710.1 764.4 $1,482.7 Earnings per share 5-year compound annual growth rate Dividends per share 5-year compound annual growth rate Stock price (end of 2016) Price/earnings ratio $ 2.84 12.4% $ 1.70 13.6% $ 30.00 10.6 $ 2.41 3.0% $ 1.32 8.0% $ 20.00 8.3 Beta Profit margin Return on equity Interest coverage ratio Ratio of total debt to total capital Bond rating 1.10 11.7% 30.3% 695.4X 0.9% AAA 1.67 5.5% 13.0% 6.9X 32.4% AAAAA a Other liabilities include trade credit (i.e., accounts payable), accrued taxes and other miscellaneous non interest bearing liabilities. b Debt-to-total capital is calculated as interest bearing debt divided by interest bearing debt plus net worth. Moody's rates the KGroup debt as AAA and S&P rates KGroup debt as AA. Exhibit 2 Pro Forma 2017 Results Under Alternative Capital Structures ($ in millions except per share data)* Pro Forma 2017 for Status quo Projected 20171 30% Debt to Total Capital $4,131.2 $4,131.2 799.6 799.6 Sales Earnings before interest, taxes & depreciation Earnings before interest and taxes Interest expense Earnings before taxes 754.6 754.6 1.1 753.5 31.2 723.4 Taxes3 256.2 497.3 0.4 246.0 477.4 0.4 496.9 477.0 Earnings after taxes Dividends on preferred stock Earnings available to common shareholders Dividends on common stock 4 Average common shares outstanding (millions)5 $ 295.3 $ 286.2 155.5 141.1 Earnings per share Dividends per share $ $ 3.20 1.90 $ $ 3.38 2.03 Beginning of Year before Re-Capitalization $ 372.0 $ 13.9 $1,472.8 $30 Beginning of Year after Re-Capitalization $ 372.0 $ 446.0 $1,040.7 Cash and equivalents Total interest paying debt Net worth (book value) Common stock price Total market value of common stock $4,665.0 * See footnotes on following page for explanations. Exhibit 3 Detailed Assumptions for Pro Forma Recapitalizations Presented in Exhibit 2 30% Debt ratio $432.1 Additional Debt (millions) Reduction in common shares outstanding (millions of shares) 14.4 1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase common stock. All repurchases are assumed to be executed in February 2017. The "status quo" pro forma capital structure assumes that NEC will begin in 2017 with its 2016 capital structure strategy unchanged. 2. The interest rate on debt in all recapitalizations is assumed to be 7% before tax. 3. A tax rate of 34% is used. 4. The dividend payout ratio is 60%. 5. Stock is assumed to be repurchased at a price of $30 per share, which was the prevailing stock price in February 2017. 6. Details of recapitalization are in $ millions