Case 83

Armstrong Production Company

Capital Structure
Directed

Armstrong Production was founded in the early 1970s as a joint venture between a plastic manufacturer and a building materials outlet chain. The company was developed to produce plastic components for use in construction. The initial market for production was the outlets retail centers. The company believes that the products durability and the economical cost of plastic allow it to replace wood for many building purposes. The companys major production facility is located on the east banks of the Mississippi, outside St. Louis. It has good access to the interstate highway system, major rail systems, and barge transportation. The location provides ideal access to the retail service centers, scattered throughout the United States. The central location also provides excellent potential for developing related markets. Based on capital provided by the partners and loan guarantees backed by the assets of the founders, the company obtained low interest economic development loans from the state of Illinois. With cheap start-up capital and a rapidly expanding market, the company was able to break even within three years. Armstrongs initial success provided the resources for a strong research and development division, and the company became the industry leader for synthetic building materials used in high-end commercial and residential construction. The companys growth was extraordinary, and demand for the new material quickly exceeded production capacity. In 1978, the company decided to undertake a major expansion that would triple output. To utilize this additional capacity, the company added direct sales to larger contractors and wholesale to other retailers. Strong market share in a growth industry allowed the company to go public and nance the expansion with an initial public offering (IPO) of 15 million shares. Corporate executives and members of the board of directors currently own 20 percent of the shares, and the company employee stock ownership plan owns another 13 percent. Immediately following the stock issue, the capital structure of the company dropped to 10 percent debt. During the 1980s, construction was booming, and the company continued to grow. To handle the nancial decisions, the company hired Bob Enderson as Chief Financial Ofcer. Bob felt that the company was nancially sound and was pleased with past performance. In 1984, he persuaded the company to develop a new line of products because he believed the national trend toward diversication would nancially strengthen the company. The new line included outdoor items such as patio furniture, picnic tables, and play equipment, as well as indoor items such as brightly colored childrens bedroom and playroom furniture. He argued that the companys expertise in plastics and industry recognition for quality products could be readily transferred to this new line of household

Copyright 1994. The Dryden Press. All rights reserved.

1998 South-Western, a part of Cengage Learning

durables. He also felt that the national marketing advantage of the companys existing retail clients and the national increase of disposable income would make the expansion a sure re winner. Bob also noted the recent activity in corporate takeovers around the country. Raiding companies were using debt to purchase protable companies with high equity capitalization. He was concerned that the companys low level of debt may make it an attractive takeover target. Therefore, he persuaded the board to undertake the expansion through new debt. Although interest rates were high, money was readily available, and company earnings were strong enough to support the required fixed interest payments. He argued that debt financing would not require the company to issue new shares, and the company could avoid dilution of ownership. He also explained that increased debt would allow the company to leverage shareholders equity and increase ROE. The nal decision followed a lengthy heated discussion about the dangers and benets of debt, and the company issued $145 million in bonds. By 1990, earnings hit an all time high of $115 million, and the board of directors was very pleased with the financial decisions of the company. Debt levels had been reduced and reinvested earnings had allowed the company to grow. However, the following year the construction boom ended. Demand for building materials was severely curtailed. Diversification provided a buffer against the construction downturn, but many companies were downsizing. The resulting layoffs negatively affected consumer purchase of discretionary items such as the companys household durables. Armstrong weathered a few tough years, and by 1996 earnings before interest and taxes had stabilized at $85 million. The companys debt is currently $110 million and represents roughly 25 percent of the companys capital structure. Several board members were concerned about the risk of bankruptcy if earnings continued to fall and had met with Bob to urge a reduction in the debt level. In response to these concerns, the planning committee developed the following earnings scenarios. There is a 20 percent probability that EBIT would drop to $40 million if additional stores were closed and construction continued to decline. There is a 20 percent probability that EBIT would increase to $130 million if a new international exporting campaign was successful. This campaign utilizes existing capacity and does not require additional capital expenditures. There is a 60 percent probability that the EBIT would remain at $85 million. The planning committee also raised concerns about the impact of a change in business risk on the companys optimal capital structure. Bob was aware that the stock market was setting new records on a regular basis. The company stock price was strong with a current market price of $22 per share. Because of the companys strong reputation, he believed that it could issue new common stock and replace debt. On the other hand, he was approached by several board members who wanted to increase control by repurchasing shares with new debt. In either case, existing bond indentures required the company to refund all existing debt at par if the capital structure was adjusted through the exchange of equity and debt. Bob knows that the next annual board of directors meetings would have a heated discussion about the companys capital structure. He must develop an in-depth presentation, analyzing the companys capital structure and its impact on company risk and return. Before the meeting, he needs to determine if the companys current level of debt is optimal or if he should recommend a change. He realizes that any decision would be poorly received by some board members. In order to convince the board to accept his recommendation, he realizes the importance of explaining how various levels of debt would affect the companys market value, cost of capital, and stock price. To prepare for the meeting, Bob contacted the companys investment bankers to get estimates for the costs of debt and equity. They discussed the fact that the company was not planning to undertake any new projects requiring external capital. After much deliberation the group agreed upon the following relationship between the companys level of debt and cost of debt and equity given its degree of business risk.

1998 South-Western, a part of Cengage Learning

Amount Borrowed (in Millions of Dollars) $0 70,000 140,000 210,000 280,000 350,000

Cost of Debt 9.5% 10.2 11.0 12.7 15.2

Cost of Equity 12.5% 12.7 13.5 14.5 16.5 19.0

As Bob was preparing for the upcoming meeting, he was required to address a potentially explosive situation that was developing in Japan. Because capital structure issues were the key agenda item for the board meeting, he hired you, as a consultant, to address the pertinent issues. You are to help determine the appropriate level of corporate debt for Armstrong Production and then develop and make the presentation explaining this decision to the board of directors. He has cautioned you that the presentation must include a discussion of the various types of risk and how risk is measured. Because the meeting will focus on capital structure, he wants an explanation of how the proportion of debt affects the risk and return of the company. In order to make these concepts understandable to the board, he has advised you to prepare an illustrative example using a ROE and TIE analysis under two alternative capital structures: a) all equity with $400 million of stock, or b) 50 percent debt ($200 million at 11 percent) and 50 percent equity. In both cases assume that EBIT is based on the probability distribution developed by the companys planning committee. To assist with your analysis Bob has set up and partially completed Table 1. The presentation must also include examples and explanations of how recapitalization changes stock price, number of shares, WACC, and EPS. To assist with your analysis, Bob has set up and partially completed Table 2 where existing debt is fully refunded and the cost of all company debt and equity is based on the investment bankers feedback. Since Bob knew that business risk was an issue of concern to some of the board, he was also interested in how an increase or decrease in business risk would affect the cost of capital, the optimal capital structure, and future capital budgeting decisions. In order to develop a presentation that would be understandable to all members of the board, Bob has asked that you develop examples that treat the company as if it were not expected to grow. Thus, he has provided you with the following equations to be used in the valuation analysis. Equations Potentially Useful in Capital Structure Analysis (1) S = [EBIT kd(D)](1 T)/ks.. (2) V = S + D. (3) P = (V D0)/n0. (4) n1 = n0 D1/P. Here, S = market value of equity. D = value of new debt. D0 = market value of old debt. D1 = market (and book) value of the change in debt. (D - D0). EBIT = earnings before interest and taxes. kd = cost of debt. T = tax rate. ks = cost of equity. V = total market value. P = stock price after recapitalization. n0 = number of shares before recapitalization. n1 = number of shares after recapitalization.

1998 South-Western, a part of Cengage Learning

Aware that several board members have an aversion to debt nancing, he wants you to prepare two scenarios involving increased debt. One scenario should analyze new debt added in phases, and the other should analyze new debt added all at once. For this analysis, he has recommended that you assume the company initially would add $30 million of debt to its existing capital structure at a cost of 10 percent. Then, potentially, the company could increase its debt to $210 million by issuing $100 million at 11 percent but use $30 million of the money to refund the initial debt issue at par and $70 million to repurchase stock. Alternatively, assume the company would issue the second installment of $70 million in new debt at 11 percent without refunding the rst issue so that the companys debt would be $210 million. As Bob is preparing to leave, he alerts you to a potential problem. Susan Handilane, the marketing VP and second largest stockholder, will probably bring up the issue of expansion. Bob thinks the company would be best off, and safest, if it operates in a steady-state, no-growth situation. However, Susan uses every opportunity to argue for an aggressive growth strategy, either through internal expansion or by acquiring other companies. Susan has even argued that it would be dangerous not to grow; in her words, Companies either grow or die. You cant just sit still. Bob is sure you will be asked for your opinion on the growth/no growth situation, and how a change from a no-growth strategy to one oriented toward growth would affect the optimal capital structure, both now and in the future. For example, would it make sense to issue debt and retire stock? However, the company would need to issue more stock later to help nance an acquisition or a major expansion program. To help structure your report, Bob has developed the following set of questions. As you answer them, keep in mind that board members might ask you some tough questions about your analysis and recommendations. Put another way, the following questions are designed to help you focus on the issues, but they are not meant to be a complete and exhaustive list of all the relevant points.

QUESTIONS
1. a. What is the difference between business risk and nancial risk? Explain some of the factors that contribute to each. b. How do these risks relate to total risk? c. How does business risk affect capital structure decisions? 2. Although Armstrongs EBIT is expected to be $85 million, there is a great deal of uncertainty in the estimate, as indicated by the EBIT probability distribution given by the planning committee. Assume that Armstrong Production Company had only two capitalization alternatives: Either an all-equity capital structure with $400 million of stock, or $200 million of 11 percent debt plus $200 million of equity. a. Analyze Armstrongs expected ROE and TIE. That is, construct partial income statements for each nancing alternative at each EBIT level. Calculate the return on equity (ROE) and times-interest-earned (TIE) ratio for each alternative at each EBIT level. (Hint: Use Table 1 as a guide.) b. Finally, discuss the risk/return tradeoffs under the two nancing alternatives. In your discussion, consider the expected ROE, the standard deviation of ROE, and the CV of ROE under each alternative. 3. Assuming that Armstrong Production is not expected to grow, the equations provided by Bob can be used in the valuation analysis. a. Explain the logic of Equation (1) for a zero-growth rm.

1998 South-Western, a part of Cengage Learning

b. Describe briey, without using numbers, the sequence of events that would occur if Armstrong decided to recapitalize and how this would affect the stock price. Relate your discussion to Equations (3) and (4). 4. Use the data given in the case as the basis for a valuation analysis. (Hint: Use Table 2 as a guide. Assume that all debt issued by the rm is perpetual.) a. Estimate Armstrongs stock price at the levels of debt provided by the investment bank, assuming the existing debt is refunded at par and new debt is issued at the stated rate. b. How many shares would remain after recapitalization under each debt scenario? c. Considering only the levels of debt proposed in the case, what is Armstrongs optimal capital structure? 5. Assume that with the opposition to debt, Armstrong initially changed its total debt level to $140 million and realized the nancial values calculated in Question 4. a. It then increased its total debt level from $140 million to $210 million by issuing new debt and using $140 million to refund the earlier issue at par and $70 million to repurchase stock. Explain why the value of equity, the value of the company, stock price, and number of shares are different from those obtained in Question 4 when the company moved from $110 million debt to $210 million debt. b. What would Armstrongs share price and ending number of shares be if it increased its current debt level to $210 million without refunding the $140 million issue? (Assume that the old and the new debt issues have the same priority of claims. Also, remember that if the rm has $210 million of debt in total, its cost of debt is 11 percent, so the new $70 million debt issue will have an interest rate of 11 percent and the old debt issue will have a required rate of return of 11 percent.) Explain why the stock prices are higher than those obtained in part a. 6. In addition to valuation estimates, most managers are concerned with the impact of nancial leverage on the rms weighted average cost of capital (WACC) and earnings per share (EPS). a. Calculate the WACC at each debt level. b. Explain the relationships between the stock price and WACC. c. Calculate the EPS at each debt level, assuming that Armstrong raises new debt in a single issue and refunds old debt at par. d. Is EPS maximized at the same debt level that maximizes stock price? 7. Consider what would happen if Armstrongs business risk were considerably different than that used to estimate the nancial leverage/capital cost relationships given in the case. a. Describe in words how the analysis would change if Armstrongs business risk was signicantly higher than originally estimated. If you are using the spreadsheet model for this case, assume that the following set of leverage/cost estimates applies: Amount Borrowed (in Millions of Dollars) Cost of Debt Cost of Equity $0 0.0% 13.5% 70,000 10.5 13.8 140,000 11.5 14.8 210,000 13.2 17.5 280,000 15.8 20.1 350,000 19.5 23.8 What would Armstrong Productions optimal capital structure be in this situation?

1998 South-Western, a part of Cengage Learning

b. Explain how the situation would change if the rms business risk were considerably lower than originally estimated. 8. How do control issues affect the capital structure decision? 9. What are the major weaknesses of the type of analysis called for in the case? 10. Is the target capital structure best thought of as a point estimate or a range? Explain. 11. What other factors should managers consider when setting their rms target capital structures? 12. Now consider the possibility of expanding the business rather than maintaining a no-growth stance. On the basis of the information in the case, do you think the company should seek to grow? What impact would growth have on its optimal capital structure?

TABLE 1
Analysis of Risk (Totals in Thousands) Probability EBIT Interest EBT Taxes Net income ROE TIE E(ROE) Std dev ROE CV 0.20 $40,000 0.00 $40,000 16,000 $24,000 6.0% n.a. All Equity 0.60 $85,000 0.00 xxxx xxxx $51,000 xxxx% n.a. xxxx% 4.3% xxxx 50% Debt Probability EBIT Interest EBT Taxes Net income ROE TIE E(ROE) Std dev ROE CV 0.20 $40,000 22,000 $18,000 7,200 $10,800 5.4% 1.82 0.60 $85,000 xxxx xxxx xxxx xxxx xxxx 3.86 xxxx 8.5% xxxx 0.20 $130,000 22,000 $108,000 43,200 $ 64,800 32.4% 5.91 0.20 $130,000 0.00 xxxx xxxx $ 78,000 19.5% n.a.

1998 South-Western, a part of Cengage Learning

TABLE 2
Valuation Analysis at Different Capital Structures (000 for total $) D
$0 70,000 140,000 210,000 280,000 350,000

S
$480,000 370,157 xxxx xxxx 179,782 100,421

V
$408,000 440,157 xxxx xxxx 459,782 450,421

D/V
0.00% 15.90 xxxx xxxx 60.90 77.71

P
$19.87 22.01 xxxx xxxx 23.32 22.69

WACC
12.50% 11.59 xxxx xxxx 11.09 11.32

# Shares
20,537 16,817 xxxx xxxx 7,710 4,425

EPS
$2.48 2.80 xxxx xxxx 3.85 4.31

Optimal Debt Level (000): $xxx

1998 South-Western, a part of Cengage Learning

 1998 South-Western, a part of Cengage Learning