The Albatross and the Goat
Case 3
Spring, 2014 REVISED 3/28
Henry has decided to buy the Goat Farm. Now he needs to figure out how to finance this business. He is asking for your help.
Fortunately you remember that your friend from CMU, you know, the one with the Led Zeppelin tattoo on their ____, somehow managed to get a job with the investment banking firm of Lehman Brothers. Oops, forget that one. Didn’t that real smart girl get a job with Merrill Lyn . . . Darn it. Maybe Morgan Stanley, nope. Who should we call?
Of course you call Rowe, Rowe, and Rowe (RRR). They were a small trading firm specializing in Treasury bills. Since Treasury bills were the only thing trading for awhile, they are doing real well and just bought out two of the big guys at about 2 cents on the dollar. But you already heard all that on Twitter. Anyway, RRR provided the following:
Alternative #1: All equity. Ks = 10%
Alternative #2: Borrow $300,000 at Kd = 5% and issue equity at Ks = 11%
Alternative #3: Borrow $600,000 at Kd = 6% and issue equity at Ks = 12%
Alternative #4: Borrow $900,000 at Kd = 8% and issue equity at Ks = 14%
They also recommended that the company shoot for a market value debt ratio under 40%, a times interest earned of at least 5, and a degree of combined leverage less than 8. But they probably recommend those numbers to everybody. And of course Henry is free to do what he wants, as long as he has enough money to buy the business.
Henry wants to maximize the value of this new venture in the event that he should decide to sell. However, he is cognizant of risk.
A) Based on what you know about this company and the fact that they plan to pay dividends equal to Actual Cash
Flow, do you feel it more appropriate to assume that the business ends after 20 years OR that it is sold as a
perpetuity based on year 20 cash flows? Explain why.
B) Use data from earlier cases, as needed. Ignore the growth rate. Create a functional spreadsheet to do the following:
1) For each alternative, re-calculate Net Income adjusting for the interest expense, if any.
2) Calculate a fair market value for equity (S) based on Ks and the ACTUAL Cash Flows = (NPAT + Externality + Depr.). In year 20 treat the project cash flows as becoming a perpetuity.
3) Calculate the following for each alternative:
a) Company value (V) at time zero = MV Equity (S) + Debt (D)
b) D/V at time zero
c) TIE for year 1
d) Probability of loss in year 1. Use Standard Deviation of Net Income = $200,000.
e) DCL for year 1. Use the same fixed vs. variable designation of cost as in earlier cases.
f) WACC at time zero calculated as WACC = (D/V * Kd * (1-t)) + ((1- D/V) * Ks)
4) Which, if any, of these capital structures do you recommend? Explain why.
BONUS: 10 points to solve for the Revenue level ($ or Quantity) that gives the same market value of the firm for capital structures #2 and #3? Hint: This is pretty easy if you set up a spreadsheet. (In Excel go to “Data / What-If-Analysis / Goal Seek”). You need to Set V2 = V3 with the same Q in each ‘spreadsheet’. Create a cell V2-V3 = 0.
BONUS: 10 points to re-solve for S for each capital structure assuming that the investment ends in year 20 and is sold for book value. None of that nasty tax stuff! Does this alternative view of cash flows affect your decision?
The Albatross and the Goat
Case 3
Grading Rubric
A) Ends after 20 years OR sold valued as a perpetuity? Explain why. 10 ____
B) Create a functional spreadsheet 10 ____
1) Re-calculate Net Income adjusting for interest expense, if any. 10 ____
2) Calculate S = Market Value of Equity 18 ____
3)
a) Company value (V) at time zero = MV Equity (S) + Debt 5 ____
b) D/V at time zero 5 ____
c) TIE for year 1 5 ____
d) Probability of loss in year 1. 8 ____
e) DCL for year 1. 8 ____
f) WACC at time zero 8 ____
4) Which, if any, of these capital structures do you recommend? 13 ____
BONUS: 10 points Cheese Revenue (or Q of cheese) where V2 = V3 10 ____
BONUS: 10 points Re-calculate S if sell for book value at time 20 10 ____
Total ____
Grade _____
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