Dougall & Gilligan Global Agency

Dougall & Gilligan GlobalAgency (D & G), one of the larger advertising agencies in the world with over 11,000 employees, had its origin in 1 1! through a predecessor firm" #ts head$uarter is in the %ew &or' city of (")"A" *oreign business of D & G now accounts for +, - of the total commission and fee income" .esides, the ten largest clients provides !/ - of the income" D & G is the corporate umbrella under which five operating units are there, D & G being the largest" 1) What are the companys financial condition and performance, its funds requirements, and business risk? 1!1 ")

Sources and Applications of Funds (1

0a1or uses of funds increases in intangible assets (23/"+ 0) and net fi4ed assets (2!3"5 0)" 6his is consistent with the ac$uisition strategy pursued by the company over the past years" Another significant uses of funds are dividends (2,7 0), currency losses (2+0 0 1ust in 1 !), stoc' repurchases and other ad1ustments that could reduce shareholders e$uity" 0oreover, cash position has improved over this period (25/ 0)" 6hese uses were financed largely by the company8s profitable operations (2!70 0), the issuance of convertible subordinated debentures (231 0) and stoc' issuance (2+, 0)" 9ther minor sources of funds are increases in ban' loans (2!5 0), accruals and deferred compensations" (refer 6able 1)

#able 1$ Source and %ses of Funds (1

1!1

")

Sources
%et #ncome #ncrease in .an' %otes #ncrease in Accounts <ayable #ncrease in Accruals #ncrease in :onv" )ub" Debentures #ncrease in Def" :ompensation and ;eserves #ncrease in Acrruals <ost=;etirement #ncrease in 9ther >iabilities )toc' #ssuance !1 " !5"0 +", !0"5 31"0 !!"0 //"5 7"3 +,"0

%ses
#ncrease in :ash #ncrease in Accounts ;eceivables #ncrease in 9ther :lient .illables #ncrease in 9ther :urrent Assets #ncrease in %et *i4ed Assets #ncrease in 9ther Assets #ncrease in #ntangibable Assets Decrease in >ong 6erm Debt Dividends Ad1ustment in )hareholders ?$uity ()toc' ;epurchases, :urrency >osses, Assets write= offs)@ #otal 5/"/ 1!"0 ,"3 5"1 !3"5 /,"0 3/"+ 10"0 ,7"+

#otal

"&'$1

173"+ "&'$1

@6here is not enough information in the case about the specifics of some of these transactions" Ae put them all together recogniBing that the total change in shareholders e$uity is affected by retained earnings (difference between net income and dividends), stoc' repurchases, foreign currency translations losses or gains and other ad1ustments"

Financial (atios 6he first thing to note is that the company bills their customers and pays the media for the ads placed" 6herefore, the company has a lot of receivables and payables" 9n average, commissions and fees to D&G are only 1/- of these billings" 6he current ratio is slightly lower than the industry median (1"0,4 vs" 1"14 for the industry) and it has fluctuated very little over the past 5 years" A $uic' ratio does not ma'e sense here because the firm does not have inventories" Average collection period fluctuated without any particular trend, and it is lower than the industry (5! vs" +! days)" 6otal debt=to=e$uity ratio is higher than the industry median (,"/4 vs" 5"+4) 6his ratio is so high because it includes accounts payables (+7- of total liabilities)" 6imes interest earned has increased over the period, reflecting a slight improvement in the company8s ability to service" Cowever, it is well below the industry median (5",4 vs" 1/"34) <rofitability has increased over the years and it is above the industry" <rofit before ta4es are "3- vs" /"1- for the industry" 6he company8s <D? ratio has fluctuated over the years and it is currently at !,"14 vs" the 13"+4 industry median" (refer 6able !) #able )$ Financial (atios

1991 Liquidity Ratios Current Ratio Average collection period De bt Ratios Total Debt to !"uit# %T Debt & !nterpri'e (alue %T Debt & Tangible A''et' )ntere't *earing Debt & !*)T Cove rag eRatios Ti+ e' )ntere't !arned ,!*)T&)ntere'tProfitability .et /ro0it 1argin /ro0it *e0ore Ta3e' & 4ale' Marke t !alueRatios /&! Ratio Dividend 5 ield 1.05 51.42

1992 1.09 45.65

1993 1.10 38.48

1994 1.06 42.15

Indus try 1.1 52

6.98 0.11 0.13 2.$0

6.20 0.12 0.15 2.51

$.43 0.14 0.12 2.14

6.89 0.14 0.12 2.63

4.5

4.44

4.09

4.68

4.61

13.8

4.$2 9.22

5.32 9.82

5.$2 10.22

5.62 9.82

3.12

24.15 0.35

29.93 0.31

30.00 0.28

26.0$ 0.33

18.5

P"# Ratios for Co$ %e titors 6oote7 Cone and *elding )nterpublic 8roup 9+ nico+ 8roup :// 8roup 1ean 1edian

18 19 16 2$ 20 18.5

*usiness (isks Cyclical risk E Aorldwide spending on advertising has increased in 1 5= +, driving company8s revenues" Cowever, spending on advertising is highly correlated with the level of economic activity in a country" .ecause it is a discretionary e4pense it is one of the costs that companies cut first in the event of an economic turndown" Seasonal risk E 6here is a moderate seasonality in the demand for advertising services with an increase towards the year=end" Currency risk E *oreign business account for +,- of total commission and fees" D&G has no hedging strategy and incurs significant translation gainsDlosses when 2Dforeign currency e4change rate changes" Uncertainty of the information technology development E Advertising agencies are aggressively pursuing participation in interactive communication an the internet" 6his is a new area for advertising and its future and development are uncertain" Competition E 6he company is one of the three largest players in the industry, and the competition is intense" )uccess is determined by the balance between efficient operations and a creative edge" Liquidity- Although they try to collect payments and pay at about the same time, a small increase in the gap of collections vs" payables could have a large effect on the company8s need for cash" Company specific risk- 6he company8s beta is 1"/ compared to 1"1 industry average" )) +o the e,istin- means of financin- unduly restrict the company?

6he following table summariBes the past financing decisions of the company and its implications" #able .$ /haracteristics of 0ast Financin-

#ype of Financin#erm

*ank *orro1in)hort=term

2on-!term +ebt , long=term loans

/on3ertible /ommon!Stock Subordinated +ebt !0=year (due 0arch >ast issuance in 1 ! !01/) <ublic

4n3estor 5 2ender !/ ban's

#nstitutional investors <ublic (insurance companies)

0urpose

*inance a moderate bulge in receivables at *inancing specific year end and buildup ac$uisitions or in assets investments (ac$uisitions)" <rime rate F 3"+2/50 million

*inance buildup in <ay down e4isting current assets and debt and fund wor'ing ac$uisitions and offset capital foreign e4change translation losses" )ubscription price 271"+ 2+, million (1 ! issuance)

/ost Amount

*i4ed rate coupons in the 3"!+- to 11"++"7+range 2!11 as of 1 5 231 million

/onditions 5 (estrictions 5 6ther /onsiderations

)ome secured with assetsG some unsecured but sub1ect to loan :onversion price agreement" :ovenantsH 2113" :allable after ;estrictions on large 0arch 1 +" #nitial ac$uisitions, additional call price 210+"7+ indebtness, net worth and investment in fi4ed assets" Ailling to renegotiate a longer term sub1ect to continued profitability" #nvestors are not very happy with the performance of this investment" :urrently trading at 277"!+ per 2100 face value

Cigher beta than the industry (1"/ vs 1"1)

)ome concerns with repurchase of stoc'" (elationship 1ith Ailling to increase in3estors credit lines up to 25!0 million"

)ince 1 ! the price has fluctuated a lot (2/,"7+ to 2111"1! range)" %ow trading at 2,5"

6he company still has 2133 0 of available credit on ban' lines, and they can negotiate 230 0 additional" 9n the long=term debt instruments, the company agreed to certain covenants that restrict additional indebtness and new investments" Cowever, this can be waived by means of a higher interest rate and the investors are open to renegotiate" ?.#6 D #nterest e4pense is +"04, above the /4 theoretical benchmar' and reflecting enough capacity to cover debt interest" 9n the negative side, those who invested in the convertible debt are not very satisfied with the performance of their investment" #t is currently trading at 277"!+ per 2100 face value (the conversion price is 2113 and the stoc' is currently trading at 2,5)" *urther more, the debt to e$uity ratio is currently ,"/ compared to 5"+ for the industry and >6 debt to capitaliBation is 1!- vs" ,- for the industry" Debt service coverage ratio calculated with ?.#6 is 0",/, but it should loo' better if calculated with ?.#6DA (unfortunately we could not find enough information on depreciation)" 5

#n summary, D&G faces some restrictions as a conse$uence of its past financing decisions, but we believe that the company will be able to finance the e4pansion pro1ect and will have to choose among different alternatives"

.)

Analy7e the financin- alternati3es as to 1hich best fits +89s situation$

6o answer this $uestion we provide two tablesH the first one describes the specifics of each alternative, and the second one is a discussion of the several criteria that should be considered for capital structure and financing alternatives decision=ma'ing" #able "$ /haracteristics of Future Financin- Alternati3es

#ype of Financin- *ank 2ines of /redit #erm 2oan +ebentures /ommon Stock )hort=term 7 to 10 years !0 years #erm <rivate placement = 4n3estor 5 2ender )ame ban's same insurance <ublic offering <ublic offering companies ?4pansion plan in )outheast Asia and >atin America 0urpose 10"!+- for a 7=year term and 10"7+- for a 10"+-" )pread F !)hare price F 2,5" <rimeF3"+- or 10=year loan" >egal of the proceeds" >egal (nderpricing ,- to /ost primeI0"+-F - if the costs F 2100 J" costs F 2!,0 J" 10- F 2+7", to ,0"!" lines are increased Average interest rate Average interest rate >egal costs F 2/+0 J of e4isting loans F on term loans F 10" 10"7/2/00 million Amount Does not allow :urrent lines of 2/50 prepayment" million, less 21+! used :ovenantsH F 2133 available" 1):urrent ratio KF 1H1" Additional 230 million !) (.an' loansI>6 can be negotiated, but debt) D :apitaliBation the rate will be higher LF7+-" /) I0"+- " 6he company #ntangible also needs some assetsLF25+0 0" 5) borrowing capacity for %o further indebtness" emergencies" ?ven +) DividendsD%et with the 230 increase profitLF/+-" ,) lines are not sufficient >eases sub1ect to to cover the needs" approval" ;ating will fall from ... to .." + years deferred call protection" )in'ing fund starting on year 10" ;e$uires waiver :onvertible debt from current lenders holders (2113 (institutional investors) conversion price) of the term loans, could protest if the raising int rate to company issues stoc' 10" - " at that price" ;atings could fall from .aa=! D ... to .a=! D.. or .a=/ D ..=

/onditions 5 (estrictions 5 6ther /onsiderations

#able :$ /riteria for +ecision!;akin-

/riteria

*ank 2ines of /redit

#erm 2oan

+ebentures

/ommon Stock

(nder the current scenario (21 ! 0 pro1ected ?.#6) the best alternative is e$uity" 6he indifference point between .an' >ines and ?$uity is 2!0+ 0" .elow that e$uity is better, above 2!0+ debt is better" .ecause long <*4#!<0S Analysis term debt has higher costs, the indiference point between debt and e$uity in this case is higher, 2!/+ 0" 9nly if ?.#6 is higher than 2!/+ it would be better to be financed with long term debt" 6he two long term debt alternatives (term loans and debentures) are very simmilar in terms of costs" )ee additional analysis and graph" +ebt (atios >6 Debt to :apitaliBation #nterest .earing Debt to ?.#6 10"70!1", !1", 10"70.oth the term loan and the debentures alternative increase substantially the >6 debt to capitaliBation ratio /"37 /"37 /"37 !"/1 6hese figures are the same for the three types of debt and contrast sharply with the ratio that the company currently has of !"/1 (that would be maintained if the company goes with e$uity)" 7"!0 7"!0 7"!0 /"/1 All the ratios seem very high" Cowever, it is important to note that in this case debt includes the huge ammount in accounts receivables" Any type of debt would increase this ratio to 7"!, but an e$uity offering would reduce it significantly" 6he company currently has a ,"/ ratio compared with a 5"+ for the industry" !" + 6imes #nterest ?arned !"7, !"7+ +"0+

Debt to ?$uity /o3era-e (atios

6his is ?.#6D#nterest ?4pense" :urrently, the company has a +"0+ ratio that compers favorably to the industry figure of /" A common stoc' issuance would not have any effect on this, but any 'ind of debt would reduce the coverage of interests" %otice that the difference among the three types of debt comes from the different interest rates" 0"!! 0"+7 0"+7 0",/ 6his ratio measures the ability to cover not only interests but also principal payments" 6he formula is ?.#6 D (#nterest I <rincipal paymentsD(1=ta4 rate)" ;emember that principal payments are ad1usted by the ta4 rate because they are not deductible" 6he number for .an' lines of credit is smaller because the we included the whole amount of debt as a current maturity" 10"!+- for a 7=year term 10"+-" )pread F !- of the )hare price F 2,5" and 10"7+- for a 10=year proceeds" >egal costs F (nderpricing ,- to 10- F loan" >egal costs F 2100 2!,0 J" Average interest 2+7", to ,0"!" >egal costs J" Average interest rate of rate on term loans F 10" - F 2/+0 J e4isting loans F 10"7/6hese are basically the direct costs of each type of financing in the form of interest rate, legal and out=of=poc'et e4penses" <rimeF3"+- or primeI0"+-F - if the lines are increased 6he companyMs credit ;atings could fall from rating could be .aa=! D ... to .a=! D.. downgraded from ... to or .a=/ D ..= .." 6here is not enough information to assess the chance of a better credit rating, but certainly it should not be ad1usted downward"

Debt )ervice :overage

<,plicit /osts

(atin-s

#able :$ /riteria for +ecision!;akin-$ /ontinued=

/riteria *ank 2ines of /redit #erm 2oan +ebentures /ommon Stock 6he president of the firm argues that the stoc' is currently undervalued because the mar'et doesnMt understand the e4pansion plan" #f they must sell stoc' he says they should wait until the price goes up"

#imin-

6he #. e4pects interest rates to raise and therefore recommends to seiBe the opportunity with a debt issue as soon as possible"

Fle,ibility

Cigh" *or their short=term nature, lines or credit would obviously be the most fle4ible means of financing, because after one year the company could do practically anything"

0edium=>ow" ?ven though a 6erm >oan has less covenants than Debentures, it still seriously limits the companyMs financing ability"

0edium" *inancing with >ow" .y issuing e$uity has the advantage of debentures, the company improving the D=? ratio" will be constrained in *luctuations in capital numerous ways that limit mar'ets could somewhat its future borrowing ability" restrict future decisions, such as stoc' repurchases" 6he effect for common stoc' is the opposite" .y reducing ris' it reduces the value of e$uity relative to debt" 9n the other hand the increased e$uity gives the management some breadth which might ma'e them ta'e away focus from efficiency"

A-ency /osts

Ae can thin' of the value e$uity as being e$uivalent to a call on the value of the firm" 6he higher the ris' the higher the value of the call" .y increasing debt level the company becomes more ris'y" 6herefore having more ris' increases the value of e$uity" .ut total value of a firm is constant (0odigliani=0iller)" 6herefore the increased leverage reduces the value of debt" An offsetting effect is that the increased leverage obligues stoc'holder management to be more careful and more efficient because they constantly need to worry about servicing debt" #t is unclear for this company which of both effects is more important (it depends more on factors such as how ris' averse is the management or how much ris' there is of moral haBard)"

#a,es

)ince the company is profitable and pays an high corporate ta4 rate (5/-), there is a substantial ta4 shield in the three debt cases" 6hese efects are captured indirectly %o ta4 shield" in the ?.#6=?<) analysis" #ssuing stoc' sends a bad signal, because in theory #ncreasing the line of credit the company would not #ssuing long term debt has Given that debentures are will probably signal an issue stoc' if the the positive effect of mostly used by well e4pected increase in management feels the stoc' signaling an undervalued established companies, an volume of operations, is under=valued" stoc' as perceived by the emission of them may have since this is the main use of 0anagement argues that management" a positive signaling effect" this type of financing" the mar'et doesnMt understand the plan to grow the company"

Si-nalin-

6he ?.#6=?<) analysis allows us to weight the costs of debt and e$uity for different levels of ?.#6" #n the case of debt, the costs ta'e the form of interest e4pense that is reduction substracted from ?.#6" #n the case of e$uity, the company pays no interest on that capital, so net income is higher, but the current shareholders are diluted, this means that the earnings per share could be higher or lower" #n general, we would e4pect that for lower levels of ?.#6 the company would be better off with e$uity and for higher levels of ?.#6 a debt strategy would yield a higher ?<)" *ollowing is the analysis for the four alternatives that D&G is considering" 6he 'ey points are those levels of ?.#6 at which the company is indifferent between choosing debt and e$uity" (nder the current scenario

(21 ! 0 pro1ected ?.#6) the best alternative is e$uity" 6he indifference point between .an' >ines and ?$uity is 2!0+ 0" .elow 2!0+ 0 e$uity is better, but above that point, debt is better" .ecause long=term debt has higher costs, the indifference point between debt and e$uity in this case is higher, 2!/+ 0" 9nly if ?.#6 is higher than 2!/+ it would be better to be financed with long term debt" 6he two long=term debt alternatives (term loans and debentures) are very similar in terms of costs"

#able >$ <*4#!<0S Analysis

?.#6 #nterest on e4isting debt #nterest on new debt ?.6 6a4es %et #ncome %umber of )hares ?<) #nterest ;ate :ash %eed 6a4 ;ate

*ank 2ines /ommon #erm 2oan +ebentures of /redit Stock !/+"+ !/+"+ !/+"+ !/+"+ /3"1 !7"0 170"5 7/"/ 7"1 !," /",1+ /00 5//3"1 /1"+ 1,+" 71"/ 5"+ !," /"+!0 10"+0/00 /3"1 /1"3 1,+"+ 71"! 5"/ !," /"+1/ 10",!/00 /3"1 = 1 7"5 35" 11!"+ /!"1 /"+03 %DA /00

/hart 1$ <*4# ? <0S 4ndifference /hart

5"0 /"3 /", /"5 /"!

?<)

/"0 !"3 !", !"5 !"! !"0 1+0 1,0 170 130 1 0 .an' >ines of :redit Debentures :ommon )toc' ?.#6=?<) 6erm >oan

?.#6

!00

!10

!!0

!/0

!50

!+0

#he +ecision 0s" :aidwell hoped to ma'e a recommendation to 0essrs" )tein and Aaitley and to two other members of the management committee by the end of ne4t wee'" )he was mindful of the need to retain some financial fle4ibility" 6o end up li'e )aatchi & )aatchi as a highly ris'y company was not something that she would li'e to see as chief financial officer" Cowever, she had only one voice in five on the matter" 6he NfinalO voice was that of )tein" Given management8s recommendation, it would be her tas' to present the matter to the board of directors at its ne4t meeting in five wee's" Although she had been a member of the board for over two years, one still needed to have structured, analytical bac'up for any management recommendation" 6o be less than thoroughly prepared was unthin'able"

10