Pablo Este, owner of the South American steel company, Rosario Acero, SA, is currently trying to determine his company’s optimal capital structure. Este must beside whether it should issue long-term debt in the form of bonds (notes + warrants) or long-term publicly traded stock (equity) through the company’s first initial public offering (IPO). Management is seeking $7.5 million in capital in order to (1) pay down its working-capital line of credit, (2) repay long-term debt and (3) capital improvements, among other things.
Pablo Este’s determination will arise from a variety of significant factors that play a role in the business. A quantitave analysis is provided first, then a FRICTO analysis is performed to determine whether the quantitative finding are consistent with what is best for the firm. Additionally, the Hamada equation will be used to un-leverage and re-leverage Rosario’s beta based upon the new debt/equity ratios. Finally, a WACC will be calculated to fully examine the effects of each option of the firm’s overall cost of capital.
This analysis determines which method of capital financing will produce the higher EPS at a given level of EBIT. Central to this analysis is the determination of the EBIT*, the point at which both debt and equity financing would produce the same EPS. EBIT* is found by setting the EPS Debt equal to the EPS Equity, and solving for the corresponding EBIT. (See attachment 1). Based on the forecast Rosario Acero should use the debt financing option as every forecasted year produces an EBIT higher than EBIT*.
The FRICTO (Flexibility, Risk, Income, Control, Timing, and Other Concerns) analytical framework is used to fully examine the implications of Rosario’s options to issue debt or equity.
Debt: The issuance of debt to the private bondholders will reduce the firm’s financial flexibility. New ventures or investments will be difficult to finance because lending firms will recognize a substantial amount of long-term debt on the balance sheet and will be reluctant to extend credit. This will limit the freedom the firm will have in the immediate future to expand through acquisition and make large capital expenditures. However, this effect is slightly offset by the fact that Rosario is planning to use the 7.5 million to pay down on the company’s present working-capital line of credit and to repay some long-term debt that is about to mature.
Equity: It serves to increase the firm’s borrowing power and provides more flexibility to the firm. Future capital expenditures will be more easily funded through bank lending using equity financing. This greater flexibility has to be weighed against greater EPS that will be generated through debt financing.
Debt: The case presents a debt alternative that consists of eight-year senior notes with warrants. The interest is 13% which is equivalent to $980,000 per year in additional interest expense. The intrinsic risk of debt is default, which would force the company into bankruptcy. Rosario Acero is being penalized for this added risk by paying a premium interest rate and options with potentially high profitability. There are also external forces in the economy that can affect the burden of debt; Interest rates and inflation fluctuations can alleviate or incur more impediments depending on the situation. A decrease in interest rates would be bad for Rosario Acero because it would be locked in to the fixed rate of 13%. Concurrently, with the economy in an upswing, the chance exists that the warrants issued will increase in value significantly. This will cost Rosario Acero a great deal of money when they are cashed out. Projections for the expected valuation of these warrants need to be examined to determine if the potential cost is worth the risk. However, generally the risk of debt financing is lower than equity financing.
Equity: An IPO would also incur a certain degree of risk. There is no guarantee that the shares of the stock would trade at an acceptable level. The managers of the company had bought stock at $9 per share but Pablo wanted to start the offering at a higher price. If the price was determined to be lower than $9 per share, the managers may view there shares as less valuable and insist on receiving more. Also, the size would have to be very large in order to raise the amount desired. This would result in a higher loss of control due to dilution.
Rosario Acero can pass the risk on to an underwriter for a fee of 8% and even though this cost can be reduced to 2% through a “best efforts” placement, Pablo should consider the underwriting option to hedge the risk of a first time IPO.
Income: A company’s amount of income is more important when considering debt than equity ; equity’s common stock dividends only have to be paid out when the extra corporate funds are available, while interest on debt needs to be paid each month. Based on after-tax profit projections on exhibit 6, Rosario Acero S.A. should not have a problem making an annual interest payment of $980,000 per year under the 8-year debt financing option. However, it is important to note that the provisions stated in the proposed private placement agreement (i.e. debt financing), indicate that Rosario will have to pay $1,875,000 in the seventh year of the placement, and $5,625,000 in the eighth year.
The sum of these two fixed payments is equal to the entire $7,500,000 face value of the private placement. Based on this payment plan, it is imperative that Rosario generates enough income in years seven and eight to make the fixed payments required under the terms of the private placement agreement to pay off its remaining debt. The firm must also consider any outstanding debt in the form of notes and old loans that will need to be paid in addition to the fixed payments in years seven and eight.
Control: The loss of control resulting from a capital structure decision is only applicable in the case of introducing more equity to finance the operations of a business. A firm loses control as it increases its amount of equity; the shareholders gain control of the company in terms of decision-making power. Equity financing through the issuance of an IPO is typically an effective method of obtaining money. However, the obvious risk associated with going public is the fact that a percentage of company ownership is sacrificed for the sake of obtaining funds through the equity issue. The owners of a firm will typically only decide to issue common stock when the money generated through debt to fund growth and operations becomes insufficient.
Timing: Although the next year’s forecasts seem favorable, firms in Argentina and other Latin America countries are recovering from the peso crisis, the economy is on the upswing with projected growth rates of inflation between 2.5 and 4%, and GNP growth between 1.5 and 6%.
Debt financing: There are some considerations that need to be looked at. First, with the economy in an upswing, it is likely that the stock price would increase. This would result in the warrants associated with the loan to increase in value, possibly costing Rosario Acero a great deal of money. However, it is also likely that interest rates would increase. This could mean that the fixed rate at which the loan was issued would be lower than the going rate. Since the interest rate would be locked in, Rosario Acero would benefit greatly from this. Rising inflation favors the debt option as well; resulting in the time value of money to be less than it is today, meaning that future payments on this loan will be worth less than current payment. With the principle payments being due in later years, this is beneficial to Rosario Acero.
Equity financing: As stated before, with the economy turning around, it is likely that the stock price will increase, or at least sell for the desired $9 per share. This will alleviate some of the risk associated with this option, as discussed earlier. This trend in the economy would also ensure that the IPO necessary to raise the 7.5 million would not be any larger than Sr. Este had intended, ensuring that control of the firm remain with top managers.
Looking at the consequences of timing on this decision, the debt option seems to hold more benefits, at least financially. Many of the potential risks associated with the equity option would be avoided, and although it is possible that the warrants attached to the debt would cost the firm extra money, this would likely be offset by inflation effects as well as benefits associate with their fixed interest rate.
It is important to consider timing in determining a company’s optimal capital structure. If interest rates increase after Rosario issues the bonds, Rosario would be set in on a fixed lower rate, which means that they would need to pay out less each period to its bondholders. However, the improving economy may also favor the equity option because Rosario will most likely receive more than his asking share price as the stock price increases.
Overall, the debt financing option seems better for Rosario Acero. The EPS produced are forecasted to be higher and the firm would maintain most of its flexibility and not give up any control of the firm. The risk associated with debt is less than that associated with equity financing as well. Although the income would be negatively affected in the last years of the loan due to the large payments, there should be no problem generating enough income in earlier years to cover it. Unfortunately, the timing of this will probably result in the warrants issued being worth more when they are cashed in and this needs to be examined further to determine whether this offsets the higher EPS that is generated. However, it is unlikely that the effect will be significant enough. It is recommended that, in accordance with the quantitative analysis, the debt financing option is used.
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