In late March 1996, Ralph Norwood was faced with the task of restructuring Polaroid’s capital structure. In the past, Polaroid had a monopoly in the instant-photography segment. However, with upcoming threats in the emerging digital photography industry and Polaroid experiencing recent losses in their market share due to Kodak’s competition, Gary T. DiCamillo, recently appointed CEO of Polaroid, headed a restructuring plan to stimulate the firm’s performance.
The firm’s new plan has goals such as to aggressively exploit the existing Polaroid brand, introduce product extensions, and enter new emerging markets such as Russia in order to secure Polaroid’s future. In addition to the plan, DiCamillo has included certain core objectives that Norwood would need to consider in his recommendation. These values include goals of value creation, financing flexibility, and staying with the “investment-grade” rating for bonds. His plan would have to afford Polaroid low costs and continued access to capital under alternative debt policies.
Norwood would need to access the right optimal strategy with these restrictions; that is to say that even if the most optimal capital structure was to force Polaroid’s bond rating under BBB-rated, Norwood would need to settle for some middle ground. Financing Requirements: Polaroid faces several business risks in March of 1996 that will affect its financial policy. The company must consider foreign risk exposure, demand variability, and the ability to develop new products in time and compete in a developing, innovative market.
Polaroid is still essentially a one-product line company, deriving 90% of its revenues from photographic products. Polaroid must also consider the threat that digital imaging technologies pose towards the company’s future. With the start up development of these new technologies, it is clear that Polaroid will not have a monopoly in these markets. In addition, Polaroid experiences business risk with their increasing revenues coming from developing countries. Approximately 9% of Polaroid’s sales in 1995 came from Russia.
Exhibit 2 (Information on International Revenues) shows the percent of total international sales is on the rise, while U. S sales are on the decline. Even though, Polaroid does have international lines of credit and probably other strategies to reduce currency risk, their business in these developing international markets does pose increasing market risk. The business risk from competitors and international markets does signify that Polaroid will need additional funding to keep up. The company must maintain a strong and flexible balance sheet to accommodate for future financing needs.
Another area of concern is Polaroid’s earnings coverage ratios. While Polaroid has a relatively low debt ratios that are comfortably in the AA-BBB range, the company is struggling to maintain safe earnings coverage multiples on its interest payments. The issue is magnified in the future as market equity grows thus increasing WACC. Without better earnings, Polaroid will not be able make interest payments on the additional debt required to balance the company’s optimal capital structure.
The use of debt and the resulting additional financial risk is a decision that Norwood must ultimately make. Norwood is also concerned with developing a long term financial strategy for Polaroid that will enable the company to grow according to DiCamillo’s plan. Virtually all of Polaroid’s debt is maturing within the next six years. The major components are listed below.
– $150 million in notes at 7. 25%. which mature on January 15, 1997
– $200 million in notes at 8%, which mature on March 15, 1997. Employee Stock Option Plan Loan with scheduled semiannual principal payments through 1997. Interest rate has varied over time, but is very low due to tax benefits to ESOP lenders.
– $140 million in convertible subordinated debentures at 8%, which mature in 2001. They are convertible to common stock at $32. 50 per share. They are not redeemable until September 30, 1998 unless the stock price exceeds $48. 75 for 20 of 30 consecutive trading days. Norwood wants to restructure Polaroid’s debt and equity to maximize the company’s future potential.
During this restructuring, Norwood wants to keep the cost of capital low, create value, and preserve Polaroid’s investment grade in order to allow for future borrowing at investment grade status. Polaroid’s Current Position The current capital structure is not appropriate for Polaroid, and it will inhibit the company’s ability to meet future financial demands. After analyzing Polaroid’s current debt maturity structure, the group concluded an eventual downgrade of the company’s BBB bond rating by the end of 1996 according to the coverage ratios.
The cost of debt drastically increases when a company enters the non-investment-grade status, while the switch amongst investment-grade ratings is relatively marginal. Exhibit 1 shows the maximum amount of debt Polaroid could have for each credit rating. Polaroid’s current investment-grade rating must be maintained to keep costs low and protect the Polaroid brand name. To maintain this rating, Polaroid needs to stop repurchasing stock and have an issuance of equity in 1996 to avoid a downgrade to junk status.
Polaroid needs to make these changes to its capital structure to have flexibility and preserve its bond rating. Any persisting needs can be funded through debt financing. Our Recommendation We recommend issuing $200 million in equity initially to pay off the $150M and $37. 7M debts. This will not only allow the firm access to much needed capital, but will also decrease the leverage ratio and minimize financing risk. Also, the ESOP program will be temporarily suspended to reduce leverage. Currently, Polaroid’s D/E is far too high at . 4. This additional equity brings it to a more manageable . 22. By analyzing the coverage ratios, we predicted that if equity was not issued by 1996, the company would lose its BBB rating. Our recommendation first and foremost considers the preservation of Polaroid’s BBB status. The advantage to a new equity issuance is that it will provide needed capital without damaging the company’s financial statements. This will provide flexibility for further borrowing in the future and make it easier for Polaroid to maintain its debt rating.
Furthermore, when capital is needed in 1998, we will issue $425M in 5-year bonds. This gives Polaroid the lowest WACC and maximum leverage while maintaining BBB status. At this point the ESOP program will resume with the company re-levering. With a somewhat flat yield curve, longer term bonds are not significantly cheaper to outweigh the flexibility that 5-year bonds offer. If earnings improve in 5 years, a capital structure with more leverage may be preferable. Having 5-year bonds gives Polaroid this flexibility.
Exhibits 2 and 3 show that a capital structure with a D/E between . 22 and . 26 is optimal. Given the consistent growth in market equity capital, additional borrowing and possible share repurchases will be necessary in the future to stay in this range. This strategy would open the door for Polaroid to find the optimal capital structure while still adhering to the values of the new CEO. The objective would be to choose the option with the lowest weighted average cost of capital, thus creating the most value, maintaining a minimum of a BBB rating, and also allowing flexibility.
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