RN Temp Services, Inc., franchises rent-a-nurse businesses to independent operators throughout the United States. The concept of the business is the same as other temporary help services, such as Manpower and Kelly Temporary Services, except that RN Temp Services deals only with registered nurses. (For an example of a company similar to RN Temp Services, Inc., see www.interimhealthcare.com.) The rationale behind RN Temp Services is as follows: 1. Many healthcare providers, especially hospitals, have difficulty hiring and retaining nurses, so there is almost always a demand for nursing professionals. Hospitals are the largest employer of registered nurses, employing almost 60 percent of the roughly 2.5 million working nurses. Traditionally, hospitals have been the dominant employer of nurses, but now nurses have opportunities that were not even dreamed of a generation ago. Registered nurses can work as nurse practitioners, nurse anesthetists, or critical care or neonatal specialists, all of which are in high demand today. In addition, registered nurses can work in home health agencies, nursing homes, utilization review positions, physicians offices or outpatient surgery centers, and a multitude of other nonhospital settings such as schools. Of all the work settings, hospitals are generally considered to be the least desirable because of the hard work, rigid work conditions, and irregular working hours. 2. Providers generally want to minimize fixed costs; so temporary workers often fill any staffing requirements that may not be permanent in nature. Also, when FINC 6400 Financial Management 3 vacancies occur among permanent workers, providers often need temporary nurses to carry the load until the vacancies are filled with permanent personnel. 3. Although nursing salaries have increased over the past ten years, real wages have barely kept up with inflation. Furthermore, a large number of nurses have quit the profession for a variety of reasons, including family responsibilities. Many of these nurses are willing to work occasionally but not on a permanent basis. About one in five nurses works on a part-time basis. 4. Typically, the nurses who want to work on a selective basis have spouses who provide family coverage health insurance. Also, these nurses do not require extensive fringe benefits such as pension plans or paid vacations, and because they are part-time workers, they are not eligible for unemployment insurance or workers compensation. Thus, if the average fringe-benefit package paid for permanent nurses is, say, 25 percent of salary, a temporary services company could offer a salary to its nurses 5 percent higher than can providers; could rent the nurses out at 5 percent less than it costs providers to hire permanent nurses, including all fringe benefits; and could pocket what remains of the 15 percent spread after administrative costs are paid. Note, however, that the actual rates charged by RN Temp Services franchisees are related more to local supply-anddemand conditions than to costs. Franchisees buy the exclusive right to use the RN Temp Services name within a specified territory from RN Temp Services, Inc., the franchisor. In addition, franchisees receive marketing and management support from RN Temp Services as well as the right to lease computers and other office equipment under relatively favorable terms. Finally, franchisees can purchase expendable office supplies directly from RN Temp Services, at substantial savings from retail prices. To start operations, a franchisee recruits a pool of nurses from the local labor market. Then, when a client needs a temporary nurse, the local manager matches the clients specific needs with a qualified nurse from the pool. The bill for services is sent to the client by the franchisee based on the number of hoursverified by a timecardthat the nurse works for the client. The client has no responsibility for the nurses salary or fringe benefits; this is all handled by the RN Temp Services franchisee. FINC 6400 Financial Management 4 Tiffany Radcliff, a registered nurse from Albuquerque who left the profession to get an MBA from the University of New Mexico, founded RN Temp Services in 1990. The firm grew rapidly from its base in Albuquerque, first by expanding operations into different cities across the Southwest and then by franchising into other parts of the country. Tiffany was a devout believer in the virtues of equity financing. Although the firm had issued debt periodically, especially to finance company-owned business expansion, Tiffany always used the firms free cash flow to retire the debt as soon as possible. Recent growth has involved franchising, in which the franchisee puts up the required capital, and hence outside capital has not been needed for several years. Tiffany believes that her firms high-growth days are over. First, numerous companies that offer competing services have appeared on the scene. Second, the number of hospitals, which are her primary clients, has declined over the years since she founded the firm, and a meaningful increase in hospital beds is unlikely in the foreseeable future. Third, many hospitals have created flexible staffing pools for nurses, which, for all practical purposes, are in-house temporary work agencies. Finally, many large employers of nurses are recruiting internationally, which lessens the demand for temporary workers. Thus, Tiffany expects the firms earnings to grow relatively slowly in the future. RN Temp Services has 10 million shares of common stock outstanding, which are traded in the over-the-counter market. The current share price is $1.20, so the total market value of the firms equity is $12 million. The book value of equity is also $12 million, so the stock now sells at its book value. The firms federal-plus-state tax rate is 40 percent. Tiffany owns 20 percent of the outstanding stock, and others in the management group own an additional 10 percent. Tiffanys financial manager, Paul Duncan, has been preaching for years that RN Temp Services should use some debt in its capital structure. After all, says Paul, everybody else uses debt, and some of our competitors use over 50 percent debt financing. Also, an underleveraged company is exposed to a hostile takeover because raiders can use the firms excess debt capacity to finance the bid. If the firm were to recapitalize, the borrowed funds would be used to repurchase stock in the open market, as the funds are not needed to grow the business. Tiffanys reaction to Pauls prodding is cautious, but she is willing to give Paul the chance to prove his point. FINC 6400 Financial Management 5 Paul has worked with Tiffany for the past six years and knows that the only way he can convince her that the firm should use debt financing is to conduct a comprehensive capital structure analysis. To begin, Paul arranged for a joint meeting with an investment banker who specializes in corporate financing for service companies. After several hours, the pair agreed on the estimates for the relationships between the use of debt financing and RN Temp Services capital costs, which are shown in Exhibit 1. Although RN Temp Services earnings before interest and taxes (EBIT) is expected to be $3 million in 2010, there is some uncertainty in the estimate, as indicated by the following probability distribution: Probability EBIT 0.25 $2,500,000 0.50 $3,000,000 0.25 $3,500,000 On the basis of previous conversations, Paul knows that Tiffany has two major concerns regarding the use of debt financing. First, she is concerned about the impact of debt financing on the firms reported profitabilitythat is, the impact of debt financing on net income and return on equity as reported in the firms financial statements. Furthermore, any risk implications to stockholders must be identified. To help in this regard, Paul plans to construct partial income statements (beginning with EBIT) for four levels of debt as measured by the book value Total debt/Total assets ratio: zero, 25 percent, 50 percent, and 75 percent. For this analysis, which will not be used to make the actual capital structure decision, Paul intends to use a cost of debt of 10 percent regardless of the amount of debt financing used. Second Part: In addition to financial statement effects, Tiffany is obviously concerned about the potential impact of debt financing on the firms stock price. To help address this issue, Paul is aware of a technique that can be used to value zero-growth firms at different debt levels. The best current estimates of the financing costs at six alternative debt levels are given in Exhibit 1. FINC 6400 Financial Management 6 Exhibit 1: Relationships Between the Level of Debt Financing and Capital Costs Here are the equations that will be used in the analysis: Exhibit 2: Formulas for Analysis FINC 6400 Financial Management 7 Finally, because the capital structure decision is heavily influenced by a host of qualitative factors as well as the actions of other businesses in the industry, Paul uncovered the following additional industry data: 1. The average healthcare franchise business has a times interest-earned (TIE) ratio (The ratio is EBIT/Annual Interest Payment) of 4.0. 2. RN Temp Services, Inc., has a current cash and marketable securities balance of $500,000. The average healthcare franchise business has cash and marketable securities on hand that is equal to 70 percent of its annual interest payment. 3. Additionally, Paul obtained industry capitalization data for companies that franchise professional services along with the matching debt ratings on the basis of rough guidance given by S&P Ratings Services. These data are contained in Exhibit 3. Exhibit 3: Industry Average Data and Matching Debt Ratings III Please Answer the Following Questions: Put yourself in Pauls shoes and see if you can convince Tiffany that the business should use debt financing. Be sure to recommend the optimal amount for the firm and do not forget (1) that the no-growth model can be used only as a rough guide and (2) that subjective factors are as important as numerical analyses to the final decision. FINC 6400 Financial Management 8 Optional information: Paul knows that Tiffany is familiar with capital structure theory and will want to know the value of the firm according to the Modigliani-Miller with corporate taxes model. Because most of the other board members are not familiar with capital structure decisions, conducting a tutorial on the issues involved will be necessary, including the difference between business and financial risk, the relationship between capital structure and earnings per share, and the additional qualitative factors that influence the decision. To ease comparisons, assume that the value of RN Temp Services, with zero debt financing, is $12 million in both models. 1. (6 pts) ROE analysis using the method of Scenario Analysis: Read the case and check the Input Data and Key Output in the worksheet attached, Project_Excel. a. Construct partial income statements for each of the four financing alternatives given in the case at each earnings before interest and taxes (EBIT) level. Then calculate times-interest-earned ratio and return on equity and for each alternative at each EBIT level. Also obtain expected value of ROE and standard deviation of ROE for each alternative. (For simplicity, use a cost of debt of 10% just for this sub-question, regardless of the amount of debt financing.) b. Briefly explain the financial leverage effect on ROE by using the results of 1(a). 2. (9 pts) Valuation Analysis: Read case contents and check the cost of debt/equity in Exhibit 1 and formulas in Exhibit 2. a. Estimate the firm's stock price, WACC, and EPS (shaded part in yellow in Excel) at the six different levels of debt listed in the table, assuming that the firm begins with zero debt and raises new debt in a single issue. (Hint: Please follow the formulas in Exhibit 2 step by step; n0 = 10,000,000, D0 = 0) b. Considering only the six levels of debt given, what is the optimal capital structure? c. Describe the trend of stock price, WACC, and EPS with the changes in debt ratio. 3. (5 pts) Considering qualitative and quantitative factors identified on Page 7 including industrial data and Exhibit 3, do you want to adjust the optimal capital structure you obtained in last question? Explain why.