71 - Progress Checks

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Jan 9, 2024

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Progress Checks One 1. If a company goes bankrupt, what type of investor is first in line to get (at least partially) some of their money back? a. If bankruptcy occurs, debt holders are first in line to get repaid among capital providers. Equity holders are the "residual claimants", meaning that get whatever is left after all stakeholders are paid. 2. Consider a 2-year bond that has a 7% annual coupon rate (paid semi-annually) and has a face value of $1,000? The required return (YTM) on comparable bonds is 8% APR (semiannually compounded) a. The semiannual coupon payment is equal to: FV x Coupon Rate / 2 = $1,000 x 7.0% / 2 = $35 b. Because the bond pays coupons semiannually and it has a maturity of 2 years, then there are 4 coupon payments c. The price of the bond is: P i. 3. You are interested in buying one of two 7-year bonds. The bond from AMA Corp has a yield to maturity (YTM) of 3.8%, while the bond from Gecko's Industries has a YTM of 3.5%. a. Although there isn't a lot of information, the bond by AMA Corp offers a higher YTM (and they both have the same maturity) so it is very likely that this bond is a riskier investment than the bond by Gecko Industries. 4. You are the CFO of a Canadian manufacturing company that is about to issue a new 5-year bond. Your boss, the CEO, tells you that she just read the following figures related to the Canadian economy: i) the annual inflation rate is expected at 1.8% over the next 5 years ii) the economy is expected to grow on average 3.2% per year over the next five years iii) the yield to maturity (YTM) on 5-year Canadian government bonds is 1.2% iv) the stock market is expected to generate an average annual return of 6.5% over the next 5 years. v) the spread (relative to the risk free rate) on bonds offered by other similar Canadian companies is currently at around 0.4% She then asks you to provide her a quick estimate of the return that you think should be offered in your company's new 5-year bonds. What is your best estimate for that required return? a. Recall that to estimate the required return for any financial asset we start with a benchmark risk free rate and then we add a risk premium (i.e., a spread). Thus, the required return for a bond can be estimated as: b. Required return = Risk free rate + Spread c. In this case, the Risk free rate is given as 1.2% and the Spread is 0.4%. Thus: d. Required return = Risk free rate + Spread = 1.2% + 0.4% = 1.6% 5. What is the main role of credit rating agencies (CRAs)? a. Credit rating agencies (CRAs) provide an assessment about the ability and willingness of issuers to meet their financial obligations (i.e., their credit risk)

6. You are a bond investor currently looking into investing in one of the two following two 10-year bonds: i) The bond by company Y has a credit rating of AA- ii) The bond by company Z has a credit rating of BBB+ a. A credit rating of AA- represents a higher credit quality (i.e., a lower credit risk) than a rating of BBB+. Thus bond Z, with a credit rating of BBB+, has a a higher probability of default than bond Y. Because bond Z has a a higher probability of default than bond Y, then bond investors should require a higher rate of return on it. 7. You are trying to estimate the credit rating of a company that currently has no credit rating. Which two of the following ratios would you choose to try and approximate that rating? a. Credit rating agencies (CRAs) provide an assessment of the creditworthiness of a borrower. Thus, as discussed in the slides, CRAs -among its many analyses- use financial ratios related to a firm's ability to fulfil its financial obligations as important inputs to estimate their ratings (they do use many other inputs). EBIT / Interest is a key ratio that measures a firm's ability to generate EBIT to cover its interest payments, and Debt / Capital measures the amount of debt a firm has. Other ratios may also be considered of course, but recall that credit ratings measure the capacity of a firm to pay back its debt, and thus ratios that capture this capacity are key. Two 1. Which two of the following features best describe a Preferred Share? a. Recall some of the features of preferred shares discussed in the lecture: b. - Stock-like features: it has no maturity date, pays a dividend c. - Bond-like features: Fixed dividend, essentially a perpetual bond d. - Although it has no finite term, often contains redemption / retraction features e. - It has no voting rights f. - In bankruptcy, claims on debt are paid first, then preferred stock, and finally common stock 2. What is the price of a preferred share if it pays an annual dividend of $5? The risk free rate is 3%, the required return by bondholders is 4%, the required return by preferred shareholders is 6%, and the required return by equity holders is 8%. a. P = Div / r_ps, where r_ps represents the required rate of return by preferred shareholders i. =83.33 3. You, as an investor in the common equity of a company, are entitled to a share in the operating profits of a firm. a. FALSE; Equity holders are entitled to a share in the profits (i.e., Net Income), after all other obligations are paid. The firm may choose to pay out some of those profits via dividends or retain them as retained earnings. 4. The Bonder Company is expected to pay a dividend of $5 per share next year, and that dividend is expected to grow 2.5% every year after. The risk free rate is 3%, the required return by bondholders is 4%, the required return by preferred shareholders is 6%, and the required return by equity holders is 8%. Use the single-stage dividend discount model (DDM) to estimate the fair price of the common stock of the Bonder Company.

a. 5/(8-2.5%) = d_0/(r-g) = $90 5. The Rapid company generated total net income of $100 million last year and it has 1 million common shares outstanding. Rapid's total book value of equity is $500 million. The company paid $35 in dividends to each shareholder. Answer the following questions: a. EPS i. 100M/1M =100 b. ROE i. = Net income / Avg Shareholder Equity = 100M/ 500M = 20% c. Payout Ratio i. = DPS/ EPS = 35/100 = 35% d. Retention Ratio i. 1 – PR = 65% e. Sust growth rate i. ROE * RR = 20%*65 = 13% Three 1. What is the reason the capital structure decision, through the tax shield benefit of debt, can have an effect on the value of the firms? a. Because interest expense is paid out of pre-tax income, while dividends are paid out of after-tax income 2. Since increasing leverage (i.e., debt as a source of capital) increases the tax shield benefit of debt, then companies should try to issue as much debt as they can to increase the value of the firm. a. False; Bankruptcy 3. The optimal capital structure is one that balances out the benefits of debt (mainly associated with the tax shield benefit of debt) with the costs associated with financial distress and bankruptcy. a. True 4. The capital structure of a firm refers to: a. The mixture of debt and equity used by the firm to finance its assets 5. In a world without taxes, a firm's profitability (for instance measured by ROE) is affected by the capital structure decision. a. True; Recall that even though in a world without taxes the capital structure choice does not affect firm value, a firm's profitability is still affected (good and bad outcomes are "magnified" by leverage).

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EXAM ANSWERS Question 1 The annual coupon rate is 8.26%. This is the rate at which the company should issue its bonds to maximize value. To get here, I first calculated 2 key financial ratios pertaining to leverage. Debt-to-assets and Interest Coverage. Debt-to-assets helped me as the CFO of InsulMed realize that we have a healthy percentage of our business financed thought debt - we can take on further debt if needed. Interest coverage highlighted our ability to cover interest payments. We have a high rate granting lenders assurance. This places us in BBB or Baa2 - a lower-medium grade investment. However, still investment grade! Next, I identified the treasury yield for 5-year bonds at 4.79%. This is the risk-free rate. Next, I calculated the spread or risk premium. I looked at the yield on existing comparable bonds and found 6.75% as the annual coupon rate. Using this rate and the rate function, I calculated the spread to be 3.47%. Then, I calculated the required rate of return 8.26% by summing the risk-free rate and spread. This helped me determine the annual coupon rate to be 8.26% in order to not lose money as InsulMed Corp.

Question 2 a) The price of this bond should be $924.92. Calculated using PV function and sum of PVs. b) Unexpected new debt effects i) price Price will be affected by the risk incurred by taking on new debt. Our credit rating will suffer. The price of the 7-year bond will also lower because of the higher required rate of return. Essentially, we are more leveraged, hence more risky, so investors require higher returns for higher risks. So since the YTM increases, the price will decrease. ii) risk-free rate The risk-free rate is unaffected by the new debt. iii) YTM The YTM should increase. New debt that is unexpected by the market is NOT priced in yet – hence the YTM does not accurately reflect what investors expect from this bond. Because new debt increases risk, investors will want higher returns. This is because the bond is inherently more risky, so it should be proportionately more rewarding. iv) Coupon Rate The coupon rate will not directly change, however, RR Electronics may be inclined to change it to make the bond more appealing to investors. If management’s goal is to sell bonds, then the coupon rate should be changed to reflect the YTM – however, there are other factors to consider. c) 2 years of bond holding would give them an annual rate of return of -2.63%. To get this number, I set this DCF up: Years End of 2nd year 0 1 2 3 4 NCF -1000 $24.00 $24.00 $24.00 $989.00 PVF 1 0.97 0.94 0.92 0.89 PV -1000 23.32361516 22.66629267 22.02749531 882.1344696 NPV -49.84812729 IRR -1.32% (semi-annual) -2.63% Annual

I had to figure out the Net cash flow at each period. Then, I had to mulitply the PVF. Then, I had to sum the present values. I calculated the IRR using the IRR and rate function. I then doubled it to get the annual number. Question 3 a) see excel b) Likely negatively affected. To figure out the likely impact on their credit rating if they choose to undertake the refinancing, I first recalled that bondholders YTM is the corporations cost of debt; it is what the firm incurs because the YTM is what the investor expects in return. So, if they choose to refinance, then, their long-term debt will incrase by 60M. Their equity will also increase by 60M. Let’s see how the ratios change. Key Financial Ratios: OLD NEW Earnings per share (EPS) 0.8008 1.3208 1.8408 1.001 1.651 2.301 ROE 0.053386 7 0.088053 3 0.12272 0.038133 3 0.062895 2 0.087657 1 EBIT / Interest 3.632478 6 5.341880 3 7.051282 1 2.322404 4 3.415300 5 4.508196 7 Long-Term Debt / EBITDA 3.461538 5 2.647058 8 2.142857 1 5.769230 8 4.411764 7 3.571428 6 We notice that ROE and EBIT/Interest get lower. We notice that EPS and LTD/EBITDA increases. Why? What does this mean? Because we have less outstanding stocks, our EPS increases. This is a good sign to the public that we are doing well and believe that our stock is undervalued. This could result in more people buying the stock and increasing the value of our firm. Because we have more equity, our ROE decreases. This is not necessarily negative. Our ROE is already considerably lower than our competitors. That’s likely because we are not highly leveraged enough. Our EBIT/ Interest going down is expected with the above. It shows that we are not as able to cover interest payments as we were before (now that we have more debt). Our long-term debt over ebitda shows that we are a fairly safe firm already and becoming a little more dynamic is okay. We are still within reasonable industry levels when comparing to PortalFiber and MapleFiber.

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Credit rating is affected by 2 key financial ratios pertaining to leverage. Debt-to-assets and Interest Coverage. Debt-to-assets helped me realize that we have a healthy percentage of our business financed thought debt. Interest coverage highlighted our ability to cover interest payments. We have an okay rate granting lenders assurance. D/A increases from .6 to .71. This is going to negatively affect credit rating. IC decreased, this will also negatively affect credit rating. c) Potential impact for Aguilar family control. They currently own 45%. Buying back more shares will grant greater control of the company. 10000000 8000000 4500000 0.5625 =45%*B12 =B25/F12 Essentially, they go from controlling 45% to 56.25%. This is excellent and ideal from their perespective as we want to maximize control. d) The value of any tax shield created by this refinancing would be positive for LightCom. The total payout to shareholders and bondholders when adding debt increased because of the benefit of the tax shield. As explained by Modigliani and Miller theory, in a world with taxes, the tax shield benefit helps the company save money and payout more. This is highly significant because of the time value of money as well as the potential to accomplish more and ensure a positive NPV and IRR. Essentialy, we are being shielded from taxation. The optimal capital structure is one that balances out the benefits of debt (mainly associated with the tax shield benefit of debt) with the costs associated with financial distress and bankruptcy. This decision would move LightCom closer to their optimal structure. It increases the total payout to shareholders + bondholders through the benefit of tax-shields. Interest expense is paid pre-tax, so it is more advantageous than paying dividends after-tax. This key piece of information is why it is so significant. Everyone we care about (so just exclude the government) gets a bigger piece of the pie. e) I would recommend to Daniela Aguilar that LightCo pursue the refinancing proposal. My two important considerations are Impact on EPS and Shareholder control. The low impact on EPS is ideal. The high control for Daniela is ideal. To futher identify key capital structure decision-making criteria emerging from Modigliani and Miller’s theory, and evaluate alternative capital structures against those criteria, we can try to understand why these impacts are ideal. EPS should be as high as possible. Because Interest expense is paid pre-tax, so it is more advantageous than paying dividends after-tax. The increased leverage will increase the interest expense. Hence, it will

increase our net income. However, because of the risk of bankruptcy or financial distress, given that bankruptcy is very costly with: Direct costs: legal & administrative costs, Indirect costs: management time, negative NPV activities, foregone investments, loss of customers, problems with suppliers, retention of employees, Daniela Aguilar should not completely go all-in on debt financing. However, this is a good decision, this refinancing would improve the balance. Shareholders understand this and expect a higher return for a riskier firm, they would get a much higher return at a reasonable level of risk. We would likely stay close to the A+ category, remaining as a high- grade investment. Some additional considerations: •D/E ratio is currently low •ROA, ROE, Interest Coverage •Tax advantages (tax shield) If time permitted, I would show the following: Income -> Scenario Taxes -> Scenario It is clear that Control -> Ownership has been achieved by this decision as we are the majority shareholder. All these benefits of taking on the debt and refinancing greatly outweigh the costs or externalities. I would also have explored FRICTO more given time. Flexibility is slightly lowered. Risk is slightly increased. These are expected costs of debt. Income and control are significantly higher. These are expected benefits of debt. Taxation and others are nuanced, but we would receive a tax benefit from the debt. Question Four a) I use ROE * RR ROE = Net Inc/ BV_E = RR = 1 – PR PR = DPS/ EPS = Assume 50% long term (given) RR = 50% long term

ROE = 8% 50%*8%= 4% So, the best estimate of company’s long-term sustainabile growth starting 2027 is 4%. To calcuate the terminal growth in dividends, I can do CF_2026 * (1+4%) / (8% - 4%), then I PV it to get 117.79 as the PV of the terminal growth in dividends. b) The price per share should be 132.82. Disucssion of inputs g, the sustainable growth rate is a little too high. It is unrealistic to predict that any company will simply outperform the GDP growth rate over a large period of time. They would essentially beat the entire market and render it pointless. So, it is unreasonable. The growth rate should be lower. Likely, as we continue to stabilize and mature, it will inch closer to the GDP growth rate or inflation rate. ROE = required return is just what investors expect. It is reasonable. There shouldn’t be a market catastrophe to alter this. Although the future is unpredictable. CF_2026 is again based on an estimate of the growth in earnings per share. This is just forecasted data. We are completely in the land of estimations and guesses – although there is logic behind each number, because of how many things can vary, especially with this much time, these are not reliable estimates for financial decision-making. In all, the price determined by the DDM model is NOT reasonable. c) Three explanations. 1) g, the sustainable growth rate is a little too high. Please read b. As a financial manager, I would be uncomfortable with assuming a growth rate of 4%. Although, in Ivey, we are taught that a growth rate between 3-5% is acceptable, this is not realistic in the real world. A 5% growth rate company would cannibalize the entire market within years. 2) CF_2026 is too high. Please read b. 0.26 0.32 0.24 0.12. These are the Year-over-year growth rates for the EPS. These are incredibly high and do not correspond to rates seen in any industry. How is it possible for a company’s EPS to grow by 30%+ in 2023, followed by a steady increase of at least 3% per year after 2027? This is a ludicrous range of difference and can not be fully explained by different stages of growth. Either there is some dishonest accounting, or, these forecasts are peculiar. 3) PVF is based on expected growth – this could also be innacurate. If so, then the NPV of the stock would be different. Alternative corporate objectives for LuxiFit and a financial manager’s perspective’s impact on his/her decision-making is analyzed.

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