CASE

13

Baines Investments, Inc.

Baines Investments, Inc. is a privateequity investment company located inDallas, Texas. The firm specializes ininvesting in privately owned fmns that itfeels it can sell in the future at a higher priceor eventuaUy take pub lic. In most cases, thefirm engages in leveraged buyouts, in whichit borrows money to buy a publicly tradedcompany with the intention of taking itprivate. After restructuring the fmn byselling off unnecessary assets and tighteningbudgets to increase profitability, Baineslnvestments and other participatinginvesting firms eventually hope to take thecompany back to the public market at amuch higher price than they paid to take itprivate.

ships for the U.S. govemment. It alsoproduces automatic flight control radarsystems and intercept missiles. It isprivately traded.

Joel's firm normaUy took the presentvalue of future dividends, eamings, orcash flow to determine value. In Joel'sfirst analysis he decided to take thepresent value of future dividends.Because dividends appeared to begrowing at a constant rate for theforeseeable future, he decided to use theconstant growth rate dividend valuationmodel in which the price (Po) or valuewas equal to

D_~ro -Ke-g

A careful analysis of company dataindicated that DI, or the next period'sdividend would be $1.80. The growth rate gappeared to be 5.5 percent. K, wassupposed to represent the cost of comrnonequity and was normally given to him inhis classroom exercises while working onhis MBA. However, his employer, Baineslnvestment, lnc., insisted that he use the

capital asset pricing model to compute thecost (or required retum) on omrnon equity.

An Upcoming Deal

Joel Horlen recently received hisMBA from Baylor University and washired by Baines Investment, Inc. In hisfirst six months on the job, he assistedother analysts in evaluating companies,but now he had an assignment of his own.

The company he was to assess isUnited Defense Systems (UDS). Thefirm manufactures warships and cargo

"'u - I0\ - '>< I -

..I

52 Case 13 Baines Ir

The term K, in the formula above represents the cost of cornmon equity, but caneasily be replaced by K the required return on cornmon equity under the.capital,asset pricing model. Once K, is computed it is merely substituted for K, in theprior formula. y.

Requi

ow the formula for K,Kj is equal to R + j3(Km - R)

where:

Kj Required retum on common stock

R Risk -free rate - use 6%

Market rate of retum - use 11%)

)

j3 Beta. The volatility of a stock's

retum relative to the market's retum.

To be determined.-,A stock with a beta of one would be as volatile as the market. A stock with a

beta of 1.20 would be 20 percent more volatile than the market, and a stock witha beta of .80 would be 20 percent less volatile than the arket and so on. Thebeta was normally computed over a five-year perio for a publicly tradedcompany.

Because the company (UDS) that Joel Horlen was evaluating was private andhad no public stock price, Joel decided to use an alternative method to computebeta. He would take the average beta of five publicly traded companies in thesame industry as UDS (Aerospace/defense). The betas for the five companies areas follows:

Company Beta

Armour Holdings 1.40

BE Aerospace 1.65

General Dynamics .85

Lockheed Martin .80

Northrop Gruman .80

Case 13

rity,but canr the.capital,ar K, in the

....)JlI\/

tockwith a.stockwithso on. Theicly traded

private andto computemies in thenpamesare

Banes Investments, Ine. 53

Required 1. Compute the average beta for the five firms in the aerospace/defenseindustry.

2. Now, compute the required rate of return (K) using the capitalasset pricing model. R is equal to 6 percent and Km is equal to11 percent.Use the formula:Kj is equal to R + f3(Km - R).

3. Next, compute the stock price (Po) using the formula:

D_~ro -Kj-g

Note K, (the required return on common stock) is being substitutedfor K, (the cost of cornmon equity). They both represent the samething, the return that stockholders demando

4. Using your answer from question 3 and assuming earnings pershare are $2.40, what is the PIE ratio?

5. Because the firm is privately held and thus the~ is no publicmarket for its securities, there will be a flqttidity discount of 20percent from the stock price computed in question 3. What will theadjusted stock price be? What will the adjusted PIE be?

6. Assume that Joel Horlen discovers that UDS is about to win amajor new defense department contract on combat radar systemsand the Company's value will increase by 40 percent. Ignoring theliquidity discount for this calculation, what will the new stock priceand PIE ratio be?

7. Discuss the impact of the company deciding to go public sometimein the future on the liquidity discount.

CASE

14

Atlantic Airlines

Atlantic Airlines issued $100 millionin bonds in 2008. Because ofthe firm'slow credit rating (B3), the bonds wereconsidered to be junk bonds. At thetime of issue, the 20 year bonds werepaying a yield of 12 percent.

Investor Tom Phillips thought theyield on the bonds was particularlyattractive and called his broker, RogerBrown, to ask for more informationon the debt issue. Tom currently heldTreasury bonds paying four percentinterest and corporate bonds yieldingsix percent. He wondered why thedebt issue of Atlantic Airlines waspaying twice that of his othercorporate bonds and eight percentmore than Treasury securities.

His broker, Roger Brown had beena financial consultant with MerrillLynch for 10 years and wasfrequently asked such questions aboutyield. He explained to Tom that thebonds were not considered investmentgrade because of the industry theywere in. Bonds of airlines areconsidered to be inherently risky

because of exposure to volatile energyprices and the high debt level thatmany airlines carry. He furtherexplained that they frequently werelabeled "junk bond s" because theirrating did not fall into the four highestcategories of ratings by the bondrating agencies of Moody's andStandard and Poor's.

Questions from Tom Phillips

This explanation did not deter Tomfrom showing continued interest. Infact, he could hardly wait to get hishands on the 12 percent yieldingsecurities. But first, he asked Roger,"What is the true risk and is it worthtaking?"

Roger explained there was a higherrisk of default on junk bonds. Itsometimes ran as high as 2-3 percentduring severe economic downturns(compared to .5 percent for moreconventional issues). Roger alsoindicated that although the yield at thetime of issue appeared high, it could go

56 Case 14

considerably higher should conditions worsen in the airline industry.This would take place if the price of oil moved sharply upward or peoplebegan flying less due to a downtum in the economy. Roger explained thatif the yield (required retum) on bonds of this nature went up, the price ofthe bonds would go down and could potentially wipe out the high interestpayment advantage.

Required 1. If the yield in the market for bond s of this nature were to go upto 15 percent due to poor economic conditions, what would thenew price of the bonds be? They have an initial par value of$1,000. Assume two years have passed and there are 18 yearsremaining on the life ofthe bonds. Use annual analysis.

2. Compare the decline in value to the eight percent initial interestadvantage over Treasury bonds (12 percent versus four percent)for this two year holding periodo Base your analysis on a$1,000 bond. Disregarding tax considerations, would Tomcome out ahead or behind in buying the high yield bonds?

3. Recompute the price of the bonds if interest rates went up byonly one percent to 13 percent with 18 years remaining. Doesthe 8 percent interest rate advantage over the two year holdingperiod cover the loss in value?

4. Now assume that economic conditions improve and the yield onsimilar securities goes down by 2 or 3 percent over the twoyears. How does Tom come out? Merely discuss the answer.No calculation is necessary.

5. If Tom holds the bonds to maturity (and there is no default),does the change in the required yield in the market over the lifeof the bond have any direct effect on the investment?

AllpresideiInstruminvestmfor thewas tocapital.compu1examinpresen1

Ininvestncurrentvery c.Instrunfuture.appropelemerHanseassistaissue (the p2Figure

Wlmakinthe cchis inwasincon

Case 14

idustry.,peopleied thatprice ofinterest

) go upuld thealue of8 years

interestercent)s on aj Tom

up byDoes

iolding

ield onrre twomswer,

efault),:he life

CASE

15

Berkshire Instruments

Al Hansen, the newly appointed vicepresident of finance of BerkshireInstruments, was eager to talk to hisinvestment banker about future financingfor the firmo One of Al' s first assignmentswas to determine the firm' s cost ofcapital. In assessing the weights to use incomputing the cost of capital, heexamined the current balance sheet,presented in Figure 1.

In their discussion, Al and hisinvestment banker determined that thecurrent mix in the capital structure wasvery close to optimal and that BerkshireInstruments should continue with it in thefuture. Of some concern was theappropriate cost to assign to each of theelements in the capital structure. AlHansen requested that his administrativeassistant provide data 00 what the cost toissue debt and preferred stock had been inthe past. The information is provided inFigure 2.

When Al got the data, he felt he wasmaking real progress toward determiningthe cost of capital for the firmo However,his investment banker indicated that hewas going about the process in anincorrect manner. The important issue is

the current cost of funds, not the historicalcost. The banker suggested that acomparable firm in the industry, in termsof size and bond rating (Baa), RollinsInstruments, had issued bonds ayear anda half ago for 9.3 percent interest at a$1,000 par value, and the bonds werecurrently selling for $890. The bonds had20 years remaining to maturity. Thebanker also observed that RollingsInstruments had just issued preferredstock at $60 per share, and the preferredstock paid an annual dividend of $4.80.

In terrns of cost of common equity, thebanker suggested that Al Hansen use thedividend valuation model as a firstapproach to determining cost of equity.Based on that approach, Al observed thatearnings were $3 a share and that40 percent would be paid out in dividends(DI). The current stock price was $25.Dividends in the last four years hadgrown from 82 cents to the current value.

The banker indicated that the under-writing cost (flotation cost) on a preferredstock issue would be $2.60 per share and$2.00 per share on common stock. AlHansen further observed that his firm wasin a 35 percent marginal tax bracket.

With all this information in hand, Al Hansen sat down to determine his firm'scost of capital. He was a little confused about computing the firm's cost ofcommon equity. He knew there were two different formulas: one: one for the costof retained eamings and one for the cost of new common stock. His investmentbanker suggested that he follow the normally accepted approach used indetermining the marginal cost of capital. First, determine the cost of capital for aslarge a capital structure as current retained earnings will support; then, determinethe cost of capital based on exc1usively using new common stock.

58 Case 15 Berks

FgurCostofdelprefe

Figure 1 BERKSHIRE INSTRUMENTSStatement of Financial Position

December 31,2010

AssetsCurrent assets:

Cash .Marketable securities .Accounts receivable .

Less: AlIowance for bad debtslnventory .

Total current assets .

Fixed Assets:Plant and equipment, original cost .

Less: Accumulated depreciation .Net plant and equipment .

Total assets .

Liabilities and Stockholders' Equity

Current liabilities: .Accounts payable .Accrued expenses .

Total current liabilities .

Long-term financing:Bonds payable .Preferred stock .Common stock } C .Retained eamings ommon equrtyTotal common equity .

Totallong-terrn financing .Totalliabilities and stockholders' equity .

Rec

$ 400,000200,000

$ 2,600,000300,000 2,300,000

5,500,000$ 8,400,000

30,700,00013,200,000

17,500,000$25900000

$ 6,200,0001,700,0007,900,000

$ 6,120,0001,080,0006,300,0004,500,00010,800,00018,000,000

$25900000

Case 15

lis firm's: cost of. the costvestmentused intal for asetermine

400,000200,000

2,300,0005,500,0008,400,000

7,500,000~

6,200,0001,700,0007,900,000

6,120,0001,080,0006,300,0004,500,0000,800,0008,000,000~--

Berkshire Instruments 59

Figure 2Cost of prior issuesofdebt andpreferred stock

Securify Year of Issue Amounf CouponRafe

$1,120,000 6.1%3,000,000 13.82,000,000 8.3600,000 12.0480,000 7.9

Bond .Bond .Bond .Preferred stock .Preferred stock .

19982002200820032006

Required 1. Determine the weighted average cost of capital based on usingretained eamings in the capital structure. The percentagecomposition in the capital structure for bonds, preferred stock,and common equity should be based on the current capitalstructure of long-term financing as shown in Figure 1 (it addsup to $18 million). Common equity will represent 60 percent offinancing throughout this case. Use Rollins instruments data tocalculate the cost of preferred stock and debt.

2. Recompute the weighted average cost of capital based on usingnew common stock in the capital structure. The weigbts remainthe same, only common equity is now supplied by new commonstock, rather than by retained earnings. After how much newfinancing will this increase in the cost of capital take place?Determine this by dividing retained eamings by the percent ofcommon equity in the capital structure.

3. Assume the investment banker also wishes to use the capital assetpricing model, as shown in Formula 11.5 in the text, to computethe cost (required retum) on common stock. Assume R = 6percent, J3 is 1.25, and Km is 13 percent. What is the value of K?How does this compare to the value of K, computed in question 1?