Rosario Acero SA Case StudyQuestion 1: Why is Pablo Este considering obtaining long-term capital? Pablo Este considered three purposes for obtaining the long term capital of 7.5 million. The first purpose was to pay down the company’s present working capital line of credit. In theoretical term a line of credit basically means an amount of funds that are available from the bank for the ongoing working capital or the cash needs of a business. The amount that is raised is often used for daily operations such as inventory purchase, purchase small equipment, manage unexpected expenditures and to cover the cyclical business fluctuations. In case of Rosario Acero the total amount needed to pay down as working capital line of credit is 4.8 million. The company has maintained its line of credit with Banco de Sol of Buenos Aires. The line was maintained 2 percent higher than the average market rate since it was not backed by any collateral that is the receivable and inventory rather was supported by personal guarantee and commercial real estate. The second purpose of long term financing is to repay the long term debt. The long term debt that the company has pursued will mature in next 6 months; therefore it is high time for the company to make arrangements to pay its long term debts. The total amount of long term debt is $9, 75,000. This is also a form of credit which is purposefully used to purchase long term assets such as buildings and heavy equipments. For any company to have healthy financial results, its long term debt should be minimum. Therefore companies should try to keep them away from the debt burden. The third and final purpose of the long term financing is for capital improvement and general purposes. In capital improvement a company basically tries to enhance or improve certain property that increases the overall value of the company. The total amount detach for capital improvement is $1,725,000. Question 2: How will the two financing alternative affect the performance of the firm? Please examine the financial forecasts contained in Exhibit 6 to Exhibit 12 in the case. The performance of the firm could be evaluated through various financial ratios and valuation of the two alternatives. The major financial ratios could be EPS (Earning per share), ROA (Return on Assets), ROE (Return on Equity), Debt ratio, and Interest Coverage Ratio. The values and the interpretation for two alternatives are as follows: 1. EPS (Earning per Share): EPS under Private Placement with Warrants 1996 1997 1998 1999 2000 2001 2002 $7.57 $4.96 $6.04 $7.29 $8.70 $10.28 $12.06 EPS under Equity Shares 1996 $7.57 1997 1998 1999 2000 2001 2002 $1.72 $1.99 $2.29 $2.64 $3.02 $3.45 EPS is computed by dividing earnings after interest and taxes by the number of shares outstanding. We can see that with private placement with warrants, companies' EPS is in increasing trend from 1997 to 0% 1999 2000 2001 2002 22. it is reasonable to increase the EPS because number of shares outstanding will remain constant.06% 1996 7.16% 5. (VAZ). case Exhibit 13).93% 7. Rosarios levered beta has been calculated. has been used to come up with return on equity (R e) for the firm by using equity as an alternative. since this company is going through losses in the most recent years.A.1% 14. It is obtained by dividing net income by the total assets of the firm. debt issuance could add value to the firm through high EPS. We have not considered Picasso Acero S.7% 13. 3.70% ROA under Equity Shares 6.3% 1996 49. With the use of various cost of equity in each year from 1997-1998.44% 6.2002.24% 6. We can see that. We have used similar method for both the private placement with warrants and equity shares to come up with the intrinsic price of share of Rosario.7% (3-month T-bill rate.A. and Velasguez S. Valuation of two alternatives using Discounted Cash Flow Method: We have computed the value of both alternatives using the average unlevered beta from the Rosario's major competitors.A (PI) to calculate the unlevered beta. in an accounting sense.93% 1999 2000 2001 2002 4. with addition to risk free rate of 5. the true bottom line measure of performance. with the issuance of equity shares. On the contrary. and a constant cost of debt of 10. With the issue of debt.8% 13.8% 21. We found risk premium by calculating nominal growth rate and deducting risk free rate from this nominal rate. 2. With the use of unlevered beta of competitors.54%. From the above calculation. It is calculated by dividing net income by the total equity of any company.93% 4. (AD). The competitors are Acero Dali S. ROE is.84% ROA of any firm is a measure of profit per dollar of assets.5% 18.38% 8. Instead. ROE (Return on Equity): ROE under Private Placement with Warrants 1996 1997 1998 49. with the use of either debt or equity does not have any greater effect on ROE.0% 24. Keeping other things constant.91% 8. Greco Acero (GA). we have computed the WACC (Weighted . The same levered beta.2% 14. and risk premium of 4.60% 5. Colon S.43% 7.6% 20.A. in both the cases ROE has decreased in comparison to the ROE of 49% of the year 1996. ROA (Return on Assets): ROA under Private Placement with Warrants 1996 1997 1998 7. we can see that either use of debt or equity has no any such large effect on the profit per dollar of assets of Rosario.5% ROE under Equity Shares 19. though it is increasing trend but less than in terms of debt issuance.5% (Exhibit 14). (CSA).76% 1997 1998 1999 2000 2001 2002 6.0% 13.5% ROE is a measure of how the stockholders fared during the year.6% 1997 1998 1999 2000 2001 2002 14. We have assumed that the stock price grows with the growth in economic activity such as GDP (6%). 20 (1.52) 0. The only difference is the use of cost of debt as the proportion of old as well as new debt. This could be a greater risk for the firm in reaching the level of EBIT.57 1999 1. The fair price of stock comes to be a negative $29.58 1998 1. Rosario Acero financial statements projections have been based on a revenue growth rate of 10.3%. the volatility in South American markets can harm the Argentina’s market. The image of Acero will be deteriorated if the supplier is not able to supply.77 for the Rosario's stock.52 (5.46) The above table shows that if Acero takeas on a private placement of eight-year notes. (Calculation in Annex 1) With the same procedure and assumptions as in the case of issuance of equity. we have valued the debt for the company. Finally.68) 0.83) 2004 2.29 0. In the case of reasonable downside scenario.0.96 (1. As per an optimistic projection. sales growth rate =4. So.12% on the basis of GNP growth rate= 10%. The forecast for annual rates of inflation is between 2.78 (1. Single supplier: Acero relies on only one primary source for the scrap metal used in its production of rolls and castings located in Buenos Aires. Therefore.47 0.25 0.71) 0. sales growth rate =10.53 2001 1.5% to 6%. could Rosario Acero continue to service its debt? The principal risks that Rosario Acero S.16 (1. faces are as follows: Debt-servicing risk: The forecasts resulting from the issue of debt gives following results: Free Cash Flow Less Interest Payments Interest Tax Shield Less Principal Payment Free Cash Flow to Equity Holders Projected 1997 1. ( 6% real GNP growth +4% inflation).63 0. (Calculation in Annex 2) Question 3: What are the principal risks the firm faces? Under some reasonable downside scenario.39) 0. So in this case the cost of debt varies in each year.5% and 4% and for Real Gross National Product (GNP) is 1.33 (1.5%.20 if firm uses a debt with warrants financing.46 (1.88) (0.56) 0. Let’s assume that the sales projections have been based on optimistic forecasts of the economy’s growth. the cash flows are not enough to cover the payments of principal in year 2003 and 2004.09 0.43 0.(Example: Mexican peso crisis had harmed the Argentina’s market back in 1994) Strong covenant risk: The debt covenants require Rosario Acero to maintain its EBIT coverage of at least 2.50 2002 1. GNP growth rate will be 10%.55 2000 1.41 (1.3% . we come up with the fair price per share of $95. As a result equity holders are provided with negative free cash flows. From this we can inferred that when GNP growth rate = 4%.87 2003 1. yielding a real GNP growth rate of 4%.63) (4.38) 0.A. the real GNP grows only by 1. the firm will need to make arrangements for refinancing for meeting the principal payment obligation. Then. Market fluctuation risk: The stock market of Argentina is tied up with South American markets. There is different WACC in this case which has been used to discount the forecasted cash flow.63) 0.5% with an inflation rate of 2.48) 0.47 (1. As a result.61 (1.Average Cost of Capital) for the company in each year. Acero will lose its customers and sales. these WACC has been averaged and used to discount the free cash flow in each year. 71 1998 37.A had been planning to issue senior notes with non detachable warrants.95 3. Item Earnings per Share EBIT/Interest Actual Projected 1996 1997 34. Further.41 -0.43 -4.42 -0.80 36.07 6.98 3.83 1.10 -0.12 -0.73 -29.64 -5.83 3.76 3. .05 2.90 1999 39.96 -4.09 0. The case also gives the base lending rate in the economy as 8.23 -27. anywhere from a few years to forever.40 3.56 1.65 -28. As also highlighted in Exhibit 14. it is not from the standpoint of the company.93 1.11 2000 40.22 -5. Generall.76 7. usually issued along with a bond or preferred stock. it can be seen that Acero would still have ability to continue servicing its debt under the downside scenario (sales growth rate of 4.The interest coverage ratio is still higher than 2 times for each of the forecast period even we use the sales growth rate of 4%.54 3.21% Revenues Cost of Goods Sold Selling.98 1.71 2.09 1.57 2.90 From the table. many companies in the similar industry are issuing debt at a rate higher than Rosario SA.54 2002 44.54 2.81 0. it will not allow the company to take the advantage of potential decline of interest rate in the economy. the warrant will simply expire or remain unused. Sales growth rate of 4.06 -0. In the case that the price of the security rises to above that of the warrant's exercise price. for an extended period.26 3.68 3.00 2.21%) Question 4: From Rosario’s standpoint.65 -0.98 1.90 -5.99 -1.77 8.19 3. are the terms of the notes and warrants package competitive and/or attractive? Rosario Acero S. the notes are not attractive as the Rosario’s coupon rate is 2.5 % higher than the base rate.63 -0.32 2001 42. Such terms and conditions although protects the potential investors from increasing interest rate risk.08 -1.98 2.58 -5.73 1. Earnings Before Interest and Taxes Interest (Notes and Old Loans) (1) Interest (New Loan @ 13%) Profit Before Taxes Taxes Profit After Taxes Profit With Extraord. & Admin.28 -30.55 -0.36 2.98 2.87 -0.26 -3.34 -34.5% plus 2%.30 6.14 -0. entitling the holder to buy a specific amount of securities at a specific price.23 2. Warrants is a certificate.03 4.51 4.00 2.08 -0.98 2.64 1.43 -0.58 -33.63 5. notes being issued at interest rate of 13% per annum payable semi-annually. then the investor can buy the security at the warrant's exercise price and resell it for a profit. Otherwise.74 -0.24 -0. That is the company cannot call the notes before 7th year.89 7. Hence looking it from the company’s perspective. the terms and conditions of issuance prohibit the company to redeem it before maturity. usually above the current market price at the time of issuance.90 -31. Although this seems attractive from investor’s perspective.27 -0.60 -0. the more the company stands to or from IPOs and other stock offerings. By becoming a publicly traded company a business can take advantage of new. Question 5: As for the possible equity issue. but we have included the impact of inflation rate as 4% in our computation. IPO gives a company fast access to public capital. . timing.Generally. The FRICTO analysis is as follows: Flexibility: When warrant is used the it may use up the firm’s debt capacity. Similarly. and other. So issuing warrants does not provide flexibility to the company. The more time remaining until expiry. which might get diluted if the warrants are exercised. use the FRICTO framework to identify the trade-offs between the two alternatives. We are not provided with clear information regarding expected growth.) From our analysis we have come to find that .77. The inclusion of warrants has no changes in the company’s coupon rates. we have assumed the growth rate to be 6%. (FRICTO stands for flexibility. Sometimes the need for additional capital in the future is for unforeseen reasons. thus precluding debt as a financing option in future years to meet the firms anticipated future financing requirements. Rosario's intrinsic equity value will be negative by $29.78 which is quite higher than the company’s offered value. the tradeoffs are very appealing to companies Risk: IPOs are also a relatively low risk for businesses and have the potential for huge gains and for huge opportunities. the attachment of warrants with the notes is viewed as a sweetener which increases the returns for the investors. Question 6: Which course of action should Este adopt? In preparing your recommendation. which. risk. The notes were being issued at high coupon rates of 13. the more time for the underlying security to appreciate. Even though public offering can be costly and time consuming. So. If one plans on exercising the warrant he must do so before the expiration date. The EPS produced are forecasted to be higher and the firm would maintain most of its flexibility due to it. will increase the price of the warrant (unless it depreciates).19 per share if the new debt with warrants is used as a financing option. in turn. Similarly. So we have decided to g for IPO rather than short notes with warrants. income. It is assumed that the stock market reflects the economy. But this is not the same in the given case. would an offering price of $9 per share be fair? Before computing the fair value for the Rosario there are certain assumptions to be made for the company. larger opportunities and can start working towards incorporation and even worldwide expansion. issue of warrants with notes threatens the existing shareholders position in the company. . The inclusions of warrants also benefit the company as it helps to reduce the coupon payments in the notes. control. the offer (IPO) price of $9 per share of Rosario stock would much lesser than its fair (intrinsic) price of $95. By sticking with this assumption we compute the fair value for Rosario. The more investors wish to invest in a company. such as a sudden investment opportunity or a financial crisis due to a severe economic downturn. But issuance of IPO would be more flexible. The risk associated with debt is less than that associated with equity financing ”. The fair value for the company is $95. 9165 0.7947 1999 0. to make IPOs more attractive.7947 2000 0. However. Under such circumstances issuance of IPO would have better tradeoff than warrants. Overall.35 0. Under such circumstances it would be better to go for IPO as well.06 4% 0. Other: Pablo Este himself is concerned about the liquidity of his investments in the firm. In this case warrants might have better benefit in terms of the management’s control over the firm. Unlevered Beta Real growth Inflation Nominal Growth rate Rosario Unlevered Beta 1997 0. This helps to encourage investors.5185 GA 1. Initially.05 1.7947 2001 0.5529 0.34 1. common stock financing always produces higher earnings after taxes than debt. Because no additional interest is paid. suggesting a growing optimism among the equity investors in Argentina . Timing: As the case describes that the economy of the country has been gaining better heights after the Mexican Peso crash.4444 0. He along with the other equity investors feels the need to increase the marketability of Rosario’s common stock. many companies will offer their initial public offering at a low rate. thinking that the new company or the newly public company will be the next big thing with a huge profit margin. Further.7947 AD 1.2933 0. So IPOs are good sources of income. Issuance of warrant does not give the warrant holders voting rights whereas that of IPOs gives the shareholders the voting rights.34 2. most of the companies issuing debts in South America have been rated below investment grade. debt financing might require high interest payments.00 0. The Merval index has risen over the previous three years. Moreover.1845 0. Control: The forecasted higher EPS also helps the firm not give up its control.34 1.4729 0. and investors will often buy IPOs. If interest rates increase after Rosario issues the bonds. the stock market had rebounded from the Tequila effect of the Peso crash. Annex 1: Computation of fair price of stock using Equity financing Competitors Levered Beta D/E ratio Tax rate Multiplier Unlevered Beta Avg. the debt financing option seems better for Rosario Acero. As prices grow and demand for the IPOs grows.2797 0. Income: For the investor. early investors stand to make a lot of profit -. which means that they would need to pay out less each period to its bondholders.9708 0. Due to this fact too it would not be wise to go for debt financing. debt financing usually (although not always under all conditions) produces higher ROE and EPS.34 1. Rosario would be set in on a fixed lower rate.7947 2002 0.7947 .and very quickly.0249 0.7165 0.7732 VAZ 1. the improving economy may also favor the equity option because Rosario will most likely receive more than his asking share price as the stock price increases.15 0. However.The market of IPO seemed to be rising though the volume is still low comparatively.1024 1998 0. IPOs are attractive mainly because they may be undervalued.79477 CSA 1. 1176 0.1216 0.1057 D/A 0.6808 1.3491 1.7787 1.6246 PV of Rosario on 1996 (end) Rosario's total liabilities in 1996 Value of Rosario's equity in 1996 No.0518 1.1164 22.7% 4.4178 1.1176 0.1267 5.105 0.3876 0.0129 1.4620 Free Cash Flow Discounted FCF FCF 2002 1.4688 0.54% 0.1216 1.D/E ratio Multiplier Levered Beta Risk free rate Risk Premium Re 1.5078 0.6541 0.1110 0.105 0.0386 1.7% 4.54% 0.2017 1.7% 4.6330 1.0903 0.0819 E/A Cost of equity Cost of debt WACC Average WACC 0.8827 1.1110 0.6124 0.1082 0. of stock outstanding Fair price per share 2002 1.1141 0.7787 6% 0.5713 0.0651 .105 0.7503 1.0257 1.54% 0.0872 0.4952 1.4549 0.54% 0.1141 0.105 0.2977 Assumed growth rate WACC 2001 1.5289 1.3164 233000 95.7% 4.3358 5.4922 0.0892 Value of all future FCFs on 2002 PV of all future FCFs 64.1057 0.105 0.42339 5.0722 5.5826 1.1082 0.0978 0.5312 0.54% 0.1883 5.5031 38.4135 1.0892 1997 1998 1999 2000 1.0844 0.3459 0.54% 0.6126 45.3255 1.7% 4.0938 0.5451 0.8 22.7784 1.4287 0.0315 1.1984 1.105 0.7909 1.7% 4.2577 5. 057 0.057 0.9166 1997 0.1549 0.7948 3.7948 1999 0.6803 0.34 1.05 1.29 36% 2002 $3.1293 0.1479 0.7218 0.1349 0.Annex 2: Calculation of fair price per share using debt with warrant financing Peer Firms Levered Beta D/E ratio Tax rate Multiplier Unlevered Beta Avg.1370 0.2782 0.1691 0.057 0.7165 0.057 0.9788 4.0454 0.34 1.39 46% Old Debt 1999 2000 $5.1492 0.3197 0.9108 2002 0.1055 2.1315 0.1349 0.5947 2.1187 Average WACC Working notes: Amount Percentage of total debt Cost 1997 $6.7613 0.7157 Real growth 0.2015 E/A 0.7948 1.3629 0.4729 0.7948 4.34 1.1669 WACC 0.6371 0.1673 0.1874 Cost of equity 0.92 $5.1438 0.00 0.0454 0.0249 0.1905 0.8327 0.35 0.7125 2.7556 2.1874 D/A 0.06 Inflation 4% Nominal Growth 0.1438 0.34 2.1276 2.057 0.4444 0.2860 3.1288 0.2797 0.1260 0.4681 1. Unlevered Beta Rosario Unlevered Beta D/E ratio Multiplier Levered Beta AD CSA 1.0454 Re 0.9708 2000 0.5529 0.7948 2.0454 0.2117 0.23 44% 41% 0.1558 2001 0.8729 VAZ 1.057 0.6148 2.7948 2.2117 0.1302 0.2933 0.5185 1998 0.1359 0.06 29% .0454 0.15 0.1901 3.105 New debt 2001 $4.4042 1.1336 0.9618 3.1549 0.1024 rate Risk free rate Risk Premium 0.0454 0.7732 0.1587 1.7985 0.2387 0.7948 3.66 47% 1998 $6.4064 GA 1.1846 0.1691 Cost of debt 0. 7787 0.7776 .50 53% 1998 7. of stock outstanding Fair price per share 6% 0.4572 9.2314 0.50 54% 1999 7.8092 FCF 2002 Assumed growth rate WACC Value of all future FCFs on 2002 PV of all future FCFs 1.50 59% 2001 7.13 2000 7.1972) 1.50 56% 0.Amount Percentage of total debt Cost 1997 7.9708) 273000 (29.50 71% 1997 1998 1999 2000 2001 2002 Free Cash Flow 1.3804 14.50 64% 2002 7.4135 1.2017 1.3255 1.1479 21.4620 1.8421 0.9120 0.8764 0.7787 PV of Rosario on 1996 (end) Rosario's total liabilities in 1996 Value of Rosario's equity in 1996 No.8 (7.6126 Discounted FCF 1.8292 22. 0693 WACC 0.50311068 38.105 0.0454 0.335861 1.794773 0.7503 2001 0.065074 .773196 0.089229491 Free Cash Flow Discounted FCF 1997 1.089229491 64.654069 0.12679 1.15 0.428681 0.612577 1.201694 1.072203 Risk free rate Risk Premium 0.105 0.794773 0.Annex 3: Calculation of Fair price of share under different assumptions Peer Firms Levered Beta D/E ratio Tax rate Unlevered Beta AD 1.093849 0.121621986 0.794772535 1997 0.794773 1.42339176 1.571319 0.34 0.108156 0.518534 0.794772535 1.413478032 1.090305 Average WACC 0.0693 0.0693 0.49224 0.454876803 0.5529 0.11636282 22.105678 0.2797 0.038646 2001 1.117648 0.1984 1998 0.00 VAZ 1.108156 0.35 CSA 1.970808 Avg.0315 1999 0.121621986 0.0693 0.387614 0.8 22.012873 1999 1.087155 0.4444 0.794773 0.8827 2000 0.31636282 1998 1.105 0.0454 Re 0.0454 0.778673 1.025679 2000 1.531165 0.62462818 PV of Rosario on 1996 (end) Rosario's total liabilities in 1996 (end) Value of Rosario's equity in 1996 (end) 45.916552872 0.7165 0.0454 0.081884 0.325469 1.051777 2002 1.545123197 0.5289 Levered Beta 1.34 0.057 0.057 0.0693 0.34 0.05 GA 1.794773 0.0454 0.110952 0.057 0.297686157 FCF 2002 Assumed growth rate WACC Value of all future FCFs on 2002 PV of all future FCFs 1.110952 0.0454 0.18836 1.345931 0.057 0.105 0.105678 D/A E/A Cost of equity Cost of debt Cost of debt (after tax) 0.468835 0.084361 0.117648 0.114103 0.105 0.34 1.097821928 0.114103 0.06 0.6330 2002 0.105 0.057 0.461992 1.50776 0.257768 1.057 0.778672702 0.612386 0.0693 0. Unlevered Beta Rosario Unlevered Beta D/E ratio 0. 77838118 Assumption: FCF after 2002 grows at 6% Hence. of stock outstanding Fair price per share 233000 95. the offer (IPO) price of $9 per share of Rosario stock would be much lesser than its fair (intrinsic) price Real growth rate Inflation Nominal growth rate 6% 4% 0.1024 .No. As for the possible equity issue. the improvement in the interest coverage ratio could be seen as a sign of a marginally better risk exposure (but look at the market trends and industry trends as well When calculating wacc. Expansion – gone through teething stages of breaking away from parent b. Which course of action should Este adopt? Mix of classes of capital 1996 1994 Liabilities/equity 6. Economic environment could be right due to trade union. would an offering price of $9 per share be fair? 6.9 1. Owners want liquidity of their investment through a share option . Are the terms of the notes and warrants package competitive and/or attractive? 5. What are the principal risks the firm faces? 4.6 (debt+notes)/equity 4.Class Answers What is the problem with the company? Wanted capital but didn’t know how to raise it Need the capital because in 93.1 EBIT/interest 2.8 EBIT/(interest + amort) 1. assumed the target capital structure was current capital structure The additional debt financing (tax shield) and dilution effect Downsides of going for debt – huge risks. How will the two financial alternatives affect the performance of the firm? 3. broke away from the Parent and made losses in 95 – period of turmoil o Labour unrest o Took on huge debt in the beginning o The market was also in a slump in Argentina – no ready customer base o Good things: companies within the trade grew – opportunity for greater demand thus needs capital to satisfy the potential demand 1. Further growth needs more capital – capital intensive industry 2. Why is Rosario considering obtaining long term capital a.9 The debt ratio is still high.3 28. Debt reduces flexibility.