Question: Capital Structure--Valuing NEXT Footwear: You’re the owner of a professional workwear and casual wear company which is wholly-equity financed with no debt

18 Feb 2024,11:35 AM

 

Question 1: Capital Structure--Valuing NEXT Footwear (20 points)

 

You’re the owner of a professional workwear and casual wear company which is wholly-equity financed with no debt. You are considering the acquisition of NEXT Athletic Footwear with the hope to further strengthen your brand name.  NEXT is a privately owned business with no market information.  Currently NEXT has no debt in its capital structure. The owner of NEXT is willing to sell the business to you for $700 million.       

 

DIVYA, is your business consultant.  She has compiled for your analysis (1) the market information of nine footwear comparables, (2) interest rate schedule for NEXT’s debt financing, and (3) the 5-year projections of NEXT’s financials after acquisition.  The analysis is detailed in the three steps below.

 

Step 1: Comparables’ Market Data

 

Comparables Market Value of  Equity Net Debt* Equity Beta D&B Shoe $       420,098  $    125,422 2.68 Marina Wilderness       1,205,795        (91,559) 1.94 General Shoe Corp          533,463        171,835 1.92 Kinsley Coulter 165560 82236 1.12 Victory Athletic 35303250 7653207 0.97 Surfside Footwear 570684 195540 2.13 Alpine Company       1,056,033        300,550 1.27 Heartland Outdoor 1454875 -97018 1.01 Templeton Athletic 397709 169579 0.98 *Net Debt = Total Debt minus Cash and Cash Equivalents

 

Other market information are as follows:

• Risk-free rate RF = 4.93%
• Market Rate of Return RM = 9.93%
• Tax Rate = 15%

 

To evaluate the fair market value for NEXT, the first step is to estimate the Asset Beta of the comparables based on their observable Equity Betas. 

 

The debt levels of the comparables are all so safe that their beta of debt (βD) are just zero.  Since the comparables will maintain a CONSTANT debt level for the foreseeable future, the beta of asset (βA) is represented by:

βA=βE1+DE×1-τ

 

D/E is Net Debt to Market Value of Equity ratio.  DIVYA’s advice is to use the AVERAGE of the comparables’ Asset Betas as the asset beta for NEXT. Using the market information above, the corresponding Cost of Asset (RA) can be determined by using the CAPM:

 

RA=RF+βA×RM-RF

 

 

 

 

Step 2: Debt Financing Schedule and Market Information

 

In the meantime, you’re considering the recapitalization of NEXT after acquisition.  It is expected that NEXT will grow steadily in market share and sales revenue over time.  However, due to the cost of funds in the financial markets and the concern for financial distress, NEXT’s interest cost increases with the debt-to-value D/(D+E) ratio.  The market view is that if NEXT’s debt-value ratio is less than 30%, the market risk of debt () is still zero; i.e.,  βD=0.

 

The best interest rate schedule that NEXT can obtain from its bankers is shown below. 

 

D/(D+E)	0%	5%	10%	15%	20%	25%	30%
Interest Rate on Debt (RD)	0%	5.0%	5.5%	6.5%	8.0%	9.0%	10.0%
Beta of Debt (βD)	0	0	0	0	0	0	0

 

Other market information are as follows:

• Risk-free rate = 4.93%
• Market Rate of Return = 9.93%
• Tax Rate = 15%

 

To determine the WACC for NEXT for each debt-value D/(D+E) ratio, the corresponding cost of equity must be determined by re-levering the asset return (RA); that is,

 

RE=RA+(RA-RD)×DE(1-τ)

 

Step 3: 5-year Projections and Assumptions (all figures are in 000s)

 

NEXT's Financial Results	2023	2024	2025	2026	2027	2028
Consolidated Revenue (000s)		$479,329	$489,028	$532,137	$570,319	$597,717
Divisional Operating Expenses		423,837	427,333	465,110	498,535	522,522
Corporate Overhead		8,487	8,659	9,422	10,098	10,583
Depreciation		9,587	9,781	10,643	11,406	11,954
Change in Working Capital		$4,569	$2,648	$9,805	$8,687	$6,234
Capital Expenditures		11,984	12,226	13,303	14,258	14,943
Notes: Divisional Operating Expenses include Depreciation. Assumption:  The FCF will grow at the constant growth rate of 5% after 2028.

 

Questions:

 

1. Is there an optimal capital structure for NEXT?  (5 points)

 

2. Determine the “best” WACC for NEXT. (5 points)

 

3. Using DIVYA’s 5-year projections and the comparables’ market information, estimate the optimal fair market value of NEXT using discounted cash flow approach.  (5 points)

 

4. Is the asking price of $700 million acceptable to you? (5 points)

 

 

Question 2:  Debt Overhang Problem (20 points)

 

Rubinstein Limited has risky assets-in-place with possible values at the end of Year 1 as presented below:

 

Rubinstein Limited				Economy	Probability	Asset Value
Assets-in Place	Debt = 35			Good	1/4	100
	Equity			Bad	3/4	10

 

Rubinstein Ltd. has full autonomy of making financial and investment decisions in the best interests of its shareholders. 

 

• Rubinstein Limited has a one-year safe project that requires investment outlay of $15 million today and will generate $22 million next year. 
• In addition, Rubinstein has $15M in cash.  This money can be either paid out as a dividend or invested.
• Currently, Rubinstein has $35 million debt in its capital structure due at the end of Year 1.  
• The risk-free rate is 10%.

 

1. What are the debt and equity value of Rubinstein based on its “best” financial and investment decision?  Explain.  (5 points)

 

2. Will debt forgiveness work for Rubinstein to invest in the good project?  What is the highest possible of amount of debt forgiveness that Rubinstein’s banker would agree?  Briefly explain.  (10 points)

 

3. Will Rubinstein fund the project by issuing debt of the same seniority?  Briefly explain. (5 points)

 

Parts (a), (b) and (c) require some simple calculations and justification. 

 

 

Question 3: Real Options and Corporate Strategy (20 points)

 

A product based on a new technology has two major potential markets. The dominant uncertainty associated with it has to do with the technology rather than the markets. Accordingly, the product will succeed in both or fail in both, with equal probability.  The markets are otherwise independent and may be entered sequentially or simultaneously either now, one year from now, or two years from now. 

 

Market A requires an initial investment of $100 regardless of when it is entered.  If the product is successful, market A will have a present value of $160 one year after entry.  If the product fails, market A will be worth $80 one year after entry. 

 

Market B requires an initial investment of $55 regardless of when it is entered.  One year after entry, B will have a present value of $140 or $25 for success and failure, respectively. 

 

For simplicity, perform all discounting in this problem at 5%.

 

Questions

 

1. (5 points) What is the NPV for each market, assuming each is entered immediately?

 

2. (5 points) Examine the possible combinations of time and place for introducing the new product. Can any possibilities be eliminated as suboptimal without further calculations? Why or why not? Which entry strategy is optimal?

 

3. (5 points) State a general capital budgeting rule for selecting the optimal strategy in this and similar problems.

 

4. (5 points) Suppose there are three potential markets, A, B, and C, where A and B are as above and C requires an investment of $40 regardless of when entered and will be worth either $55 or $40 one year later.  Test the decision rule you formulated in part (c.) above to check that it produces the optimal decision for this revised problem.

 

Please limit your answer to NO MORE than 4 pages total for this question.

Question 4: Capital Structure (20 points)

 

China Evergrande Group (stock code 3333.hk) is principally engaged in the property development, property investment, property management, new energy vehicle business, hotel operations, finance business, internet business and health industry business in the People’s Republic of China (the ‘‘PRC’’).  

 

The excel file “Q4 Financials of Evergrande” provides the following financial information for fiscal years from December 31, 2016 to December 31, 2020.

 

• Balance Sheet
• Income Statement with Earnings Summary
• Financial Ratios
• 5-year Monthly Stock Prices of Evergrande
• 5-year Hang Seng Index from Jan 2015 to Dec 2020

 

1. Describe Evergrande’s capital structure for the period from 2016 to 2020.  What are the likely factors leading to this capital structure?

 

Hint: Consider Evergrande’s sustainable growth g* and its underlying components. To many executives, growth is something to be maximized because it can increase the firm’s market share and profits as well.  But growth is NOT always a blessing and rapid growth can strain a company’s resources and lead to bankruptcy. Sustainable Growth Rate is the maximum rate at which company sales can increase without depleting its financial resources.  The sustainable growth of a firm is equal to

 

g*=1-d×AssetEquity×Net IncomeSales×SalesAssets ;  d=Dividend Payout (%)

 

If the actual sales growth exceeds the sustainable growth rate g*, the firm’s cash flows are under stress.  On the other hand, if the actual sales growth is less than g*, the firm is building up a cash surplus.

 

2. Based on the information given above, is this capital structure likely to be optimal? If yes, explain its merits relative to alternative capital structures.  If not, discuss this capital structure’s main drawbacks, as well as the relative merits of the different possible paths to a more suitable capital structure.  (Hint: Discussion in Lectures 2 and 3)

 

3. Determine the weighted average cost of capital for Evergrande at the end of 2020.  (Assumptions: Hong Kong risk-free rate = 1.5% and Hong Kong stock dividend yield = 6%)

 

Note: Total Market Return = Return on Hang Seng Index + Dividend Yield

 

In your estimation of the WACC, should the constant high level of inventory be considered as part of the non-current assets as well?  The value of equity is equal to the number of shares outstanding multiplied by the average of the high and low stock price of the year.

 

4. Determine the EVA of Evergrande for year 2020.  Did the business operations of Evergrande add value to the group?

 

EVA=EBITDA×1-τ-k×NA

 

Question 5: Valuing Risky Debt and Equity (20 points)

 

The excel file “Q5 Valuing Evergrande” provides the condensed financial position of Evergrande as at December 31, 2020:

 

Assets	Book Value (000s)	Liabilities and Equity	Book Value (000s)
Non-Current Assets	396,225,000	Non-Current Liabilities	443,475,000
Fixed Assets	94,292,000	Long-Term Debt	381,055,000
Investments	267,762,000	Other Long-Term Liabilities	62,420,000
Other Assets	34,171,000	Current Liabilities	1,507,253,000
Current Assets	1,904,934,000	Payables	621,715,000
Cash On Hand	180,744,000	Taxation	156,856,000
Receivables	46,365,000	Short Term Debt	335,477,000
Inventory	1,406,739,000	Other Current Liabilities	393,205,000
Other Current Assets	271,086,000	Total Liabilities	1,950,728,000
Total Assets	2,301,159,000	Total Equity	350,431,000

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Evergrande is in financial distress and is in default on all interim interest payments due on the total liabilities.  The creditor is assessing the market value of debt and equity. 

 

Assessment of the Market Value of Assets:

 

The inventory consists of unsold residential units. Given the dismal real estate outlook consequent to the government policy on the purpose of real estate, the inventory could only be liquidated at 40% discount in book value.  Also due to the uncertain pandemic conditions, it is estimated that 75% of the receivables are to be written off.  The total amount of non-current assets can only be liquidated at 60% of book value. The cash on hand and other current assets, however, can be fully realized in book value terms, that is, their market value is equal to the book value.  

 

Additional Market Information

 

• The uncertainty of the market value of the total assets compounded by regulatory uncertainty, COVID-19, as well as the fragile economic outlook, is conservatively estimated to be at least 50%.

 

• The risk-free rate of interest is standing at 3% and is expected to remain constant for the foreseeable future.

 

Assessment of the Market Value of Liabilities

 

Since Evergrande defaults on all its debt payments coming due, the long-term debtholders are immediately calling loans with a 6-month notice. The total amount concerned is $443,475 million. The total amount of current liabilities, $1,507,253 million are due in 6 months as well.  So, the total amount of liabilities due in 6 months is $1,950,728 million.

 

 

Based on the market-value assessment of Evergrande, the table below presents the corresponding financial position of Evergrande.

 

Assets	Market Value ($000s)	Liabilities and Equity	Market Value ($000s)
Non-Current Assets	237,735,000	Total Liabilities  (Today’s Face Value = $1,950,728,000)	????
Fixed Assets	94,292,000
Investments	267,762,000
Other Assets	34,171,000
Current Assets	885,442,950
Cash On Hand	180,744,000
Receivables	11,591,250
Inventory	562,695,600
Other Current Assets	271,086,000	Total Equity	????
Total Assets	1,263,851,860	Liabilities & Equity	1,263,851,860

 

Questions

 

1. Determine the fair market value of Evergrande’s equity today (8 points)

 

2. Determine the fair market value of Evergrande’s total liabilities today (8 points)

 

3. What is the market implied interest rate on Evergrande’s liabilities today? (4 points)

 

 

https://apaxresearchers.com/storage/files/2024/02/18/9667-xoP_11_34_48_project-acf.docx