CASE 1: The objective of the firm

Let us consider a firm with the following balance sheet and profit and loss statement:

2014 2015 2016 2017

Cash 35 40 40 45
Accounts receivable 110 135 165 211
Inventory 215 265 340 418
Prepaid expenses 30 30 30 28
Current assets 390 470 575 702
PPE 300 310 325 350

Total assets 690 780 900 1,052

Current portion of l/t debt 10 10 10 10
Bank loan 300 325 350 350
Accounts payable 80 109 144 223
Accruals 25 20 25 25
Current liabilities 415 464 529 608
Long term debt 120 110 100 90
Total liabilities 535 574 629 698
Equity 155 206 271 354

Total debt and equity 690 780 900 1,052

2014 2015 2016 2017

Sales 1,119 1,400 1,740 2,200
Opening inventory 172 215 265 340
Purchases 906 1,131 1,416 1,773
Closing inventory 215 265 340 418
Cost of goods sold 863 1,081 1,341 1,695

Gross profit 256 319 399 505

Operating expenses 170 210 267 344
EBIT 86 109 132 161
Interests 30 31 32 34
EBT 56 78 100 127
Income tax 20 27 35 44
Net earnings 36 51 65 83

Guideline for discussion:

1. Is the firm profitable? Analysis of ROA, ROE, and margin ratio.

 2. Why does the firm need money? Sources and uses of funds.

3. Is the firm well run?

4. Whose interests are at stake? Suppliers, customers, bondholders,

shareholders.

CASE 2: Capital structure: market arbitrage (I)

London Ltd. and Paris Ltd. are two firms with the same economic risk (assets risk),
whose earnings are totally distributed as dividends and about which we have the
following financial information:

LONDON PARÍS
Number of shares 30.000 20.000
Stock price 120 142
Bonds value - 1.000.000
Interest rate - 7%
EBIT 360.000 360.000
Earnings standard deviation (σBAII) 140.000 140.000

If an investor owned 400 shares of Paris, how could he increase his wealth keeping
the same financial risk?

CASE 3: Capital structure: market arbitrage (II)

Lisbon Ltd. and Rome Ltd. are two firms whose assets have the same risk. We have
the following financial information about the firms:

Lisbon Rome
Number of shares 17,000 13,000
Stock price 3,125 2,125
Debt value (10% interest rate) - 23,200,000
EBIT 8,500,000 8,132,000

Could an investor who owned 1% of Rome achieve higher return keeping the same financial
risk? What if he/she owned 1% of Lisbon?
CASE 4: Capital structure
The balance sheet of Mercury Ltd. is as follows:

PPE 1,600 Equity 3,200

Inventories 750
Receivables 600
Cash 250
Total assets 3,200 Total liabilities 3,200

The income statement reflects annual sales of 3.2 million euros, fixed costs of
640,000 euros and variable costs that account for 60% of sales. The corporate tax rate
is 40%. We also know that the firm distributes all the net profit as dividends, there are
160,000 outstanding shares, and that the required rate of return on the shares of that
company is 15%.

The company plans to restructure its liabilities to a debt ratio of 30% or 50% of
total assets. The interest rate of the debt would be in both cases 12%. We know that the
risk-free interest rate is 10%, the return of the market portfolio is 15%, and the
systematic risk measured (β coefficient) would be 1.65 for a debt ratio of 30% and 2.1 if
the debt is 50%.

For next year, the company estimates that there is a 60% probability of reaching
3.8 million euros in sales and 40% of 4.5 million euros.

Discuss the most convenient capital structure according to the following criteria:

1. Earnings per share.

2. Risk of earnings per share.

3. Coefficient of variation.

4. Market price of the shares.

CASE 5: Capital structure: debt vs. equity

Mike Smith, CEO of a glass manufacturing firm (KENDAL Ltd.) is preparing, at the end of
2018, the next meeting of the company's Board of Directors. In it, the way to finance the
capacity expansion of the factory that is expected to be executed during 2019 will be
discussed.
KENDAL, which was created in 2012, produces glass containers that sells mainly to food,
beverage, pharmacy, cosmetic and chemical companies. The breadth and diversity of its
customers makes its sales quite stable, despite the activity fluctuations of some of the
industries it serves. In the last eight years only in 2013 the sales experienced a slight
setback as a result of an economic crisis that, on the contrary, affected other companies
much more severely.
Its food and pharmacy customers are not very affected by the economic situation. The
beverage sector, somewhat more sensitive, depends more on the weather. Wine
producers, one of their main customers, depend on the annual harvest and international
economic fluctuations given their large portfolio of foreign customers. Finally, cosmetic
and chemical customers, very sensitive to the economic cycle, are currently
experiencing a significant boom due to the favorable economic situation, which has
offset the weakness of other customers.
KENDAL sales, in nominal terms, have grown since 2011 at an annual rate of 8.5%, above
the growth of the national economy and in line with the evolution of its sector. In tons,
the increase in the national glass container market was 8% in 2015, 4% in 2016 and 7%
in 2017. For 2018, an increase of 6% is estimated, offering good expectations for which
KENDAL wishes to get ready, overcoming the current limitations arising from its
restricted production capacity, which have prevented it lately from meeting some new
customer orders.
The glass packaging market is very competitive, with the sale price being quite important
in the customer's purchase decision. In recent years, manufacturers have not been able
to increase prices above inflation. Other relevant variables are the quality and weight of
the container and the reliability of the supply. In general, the design is imposed on the
manufacturer by customer specifications.
In latest years, the glass container has regained competitiveness over other alternatives
due to the recent recycling programs promoted by the Government in application of
international environmental standards. Currently more than 50% of domestic
consumption is recycled. In addition, unlike other containers, 100% of the material is
used in the recycling of glass, which has led to a greater use of this type of packaging.
KENDAL is among the top six manufacturers in the sector and its sales are approximately
a quarter of those of the leading company. Table 1 shows the evolution of its Profit and
Loss Account between 2011 and 2018. Table 2 shows the Balance Sheet as of December
31, 2017 and 2018. All the financial statements of the company are audited without
qualifications, for one of the first audit firms
 Table 1: Balance sheet

2017 2018
Cash 149 232
Accounts receivable 2,158 2,308
Inventory 1,534 1,701
Current assets 3,841 4,241
PPE 10,843 11,289
Accumulated depreciation -3,325 -3,866
Total assets 11,359 11,664
S/t bank loan 585 451
Accounts payable 1,395 1,409
Current liabilities 1,980 1,860
Long term debt 1,700 1,700
Equity 7,679 8,104
Total debt and equity 11,359 11,664

Table 2: Profit and loss account

2011 2012 2013 2014 2015 2016 2017 2018

Sales 3,593 3,751 3,701 4,078 4,598 4,801 5,768 6,345
Selling, general &
administr. expenses 2,872 2,958 3,040 3,365 3,762 3,635 4,356 4,703
Depreciation 295 315 321 334 356 520 531 541
EBIT 426 478 340 379 480 646 881 1101
Interests 267 270 234 235 289 271 219 195
Taxes 54 68 37 49 58 116 201 281
Net earnings 105 140 69 95 133 259 461 625
Dividends 40 40 40 40 60 100 150 200
# shares (thousand) 1.2 1.2 1.2 1.2 1.8 1.8 1.8 1.8
Earnings per share 87.5 116.7 57.5 79.2 73.9 143.9 256.1 347.2
Dividend per share 33.3 33.3 33.3 33.3 33.3 55.6 83.3 111.1

In addition to its national sales, the company is beginning to export packaging to some
close countries. The export activity is limited to these nearby countries due to the
aforementioned impact of transport costs.
Due to the expected increase in exports and, above all, due to the good expectations of
the national market, KENDAL has approved, after detailed technical and economic
feasibility studies, the construction of a third melting furnace and the assembly of two
new machines for bottle molding. Now the firm faces the decision of how to finance the
estimated 2,000 million euros for the new investment program.
This project will allow not only to meet the expected increase in production, but also to
incorporate into the product the R&D work that has made it possible to design lighter
and stronger packaging. As a consequence, the company intends to gain market share
to benefit from the economies of scale that regulate the performance of this sector and
improve the attributes of its product to improve its positioning. The new investment will
increase the production capacity from 130,000 tons per year to 180,000 tons.
In 2015 KENDAL made a disbursement of 3,500 million euros in order to rebuild the
refractory material of one of its furnaces, exhausted after eight years of campaign,
transform its fuel supply system, moving from fuel oil to natural gas and implant an
integrated process system, which improved the productivity and flexibility of the lines.
On that occasion, the financing was carried out through an equity increase of 600,000
shares, in the proportion of one new share for every two old shares, and a variable
interest loan of 1,700 million. The extension was subscribed, at a price of 3,000 euros
per share, by the shareholders of KENDAL. The loan will be repaid in two halves on
December 31 of the years 2020 and 2021, respectively.
The 2015 investments have allowed us to reach a capacity utilization of 93%, which is
considered excellent in the sector, taking into account the necessary stops for the
integral maintenance of the plant.
The new investment planned for 2019, and which will become operational in 2020,
consists of 1,600 million euros, in fixed assets, which is expected to be amortized in ten
years. In addition, operating working capital, that is, the sum of the operating cash,
receivables, and inventories, less supplier financing, is estimated to grow by 400 million
euros. When the new investment is fully operational, which is anticipated by 2021, it will
increase the operating profit by 330 million euros per year.
After several months of work, Mike Smith, together with the firms CFO, has identified
two possible alternatives to finance the planned investment:
In negotiations with a prestigious bank, it has achieved the possibility of obtaining a loan
of 2,000 million euros at variable interest and repay in two equal tranches in 2023 and
2024. Taking into account the foreseeable evolution of market interest rates, he
estimates that its effective cost will be 7% per year, including formalization expenses.
After consulting the current shareholders of KENDAL, which is not publicly traded, about
the viability of going to a new capital increase, they were not willing to do so, mainly
due to lack of liquidity. The majority are still amortizing the credits they had to request
to cover the disbursement of the extension made in 2015.
After numerous surveys to locate potential investors interested in subscribing an equity
increase, they contacted a solvent financial group, interested in diversifying their
investment portfolio and, perhaps, in anticipating a possible IPO of the company. This
group is the one that has offered a higher subscription price for new KENDAL shares. In
a preliminary agreement, subject to the fact that the Board effectively approves the
capital increase, this Group undertakes to subscribe 500,000 shares of KENDAL at a price
of 4,000 euros. This would mean a 22% of the ownership of KENDAL and appoint two
members of the Board of Directors.
 As its fundamentally financial and non-industrial interest, this group does not seem to
intend to be involved in the management of the company and is willing to support the
current Board. The board now has eight members, which would be expanded by two
more if the extension is accepted and controls, directly or indirectly, almost 60 percent
of the outstanding shares. The rest is quite disperse among private shareholders and
company personnel.
Tables 3 and 4 show the company's forecasts related to loan financing and capital
increase, respectively.
Table 3: Debt financing

2019 2020 2021 2022 2023 2024

Accounts receivable 3,345 3,881 4,269 4,610 4,887 5,082
PPE 13,228 13,625 14,033 14,454 14,888 15,334
Accumulated depreciation -4,430 -5,091 -5,772 -6,474 -7,197 -7,941
Total assets 12,143 12,415 12,530 12,590 12,578 12,475
Accounts payable -101 498 810 92 193 113
Long term debt 3,700 2,850 2,000 2,000 1,000 0
Equity 8,544 9,067 9,720 10,498 11,385 12,362
Total debt and equity 12,143 12,415 12,530 12,590 12,578 12,475

Sales 6599 7,655 8,420 9,094 9,639 10,025

SGAE 4,891 5,674 6,241 6,740 7,145 7,430
Depreciation 564 661 681 702 723 744
EBIT 1,144 1,320 1,498 1,652 1,771 1,851
Interests 201 243 215 172 115 46
Taxes 292 334 398 459 514 560
Net earnings 651 743 885 1,021 1,142 1,245
Dividends 210 220 232 243 255 268
# shares (thousand) 1.8 1.8 1.8 1.8 1.8 1.8
Earnings per share 361.7 412.8 491.7 567.2 634.4 691.7
Dividend per share 116.7 122.2 128.9 135.0 141.7 148.9

Table 4: Equity financing

2019 2020 2021 2022 2023 2024

Accounts receivable 3,345 3,881 4,269 4,610 4,887 5,082
PPE 13,228 13,625 14,033 14,454 14,888 15,334
Accumulated depreciation -4,430 -5,091 -5,772 -6,474 -7,197 -7,941
Total assets 12,143 12,415 12,530 12,590 12,578 12,475
Accounts payable -91 487 778 41 -876 -1,971
Current liabilities -91 487 778 41 -876 -1,971
Long term debt 1,700 850 0 0 0 0
Equity 10,534 11,078 11,752 12,549 13,454 14,446
Total debt and equity 12,143 12,415 12,530 12,590 12,578 12,475
Sales 6,599 7,655 8,420 9,094 9,639 10,025
SGAE 4,891 5,674 6,241 6,740 7,145 7,430
Depreciation 564 661 681 702 723 744
EBIT 1,144 1,320 1,498 1,652 1,771 1,851
Interests 132 103 72 26 -33 -104
Taxes 314 377 442 504 560 606
Net earnings 698 840 984 1122 1244 1349
Dividends 262 282 296 311 326 342
# shares (thousand) 2.3 2.3 2.3 2.3 2.3 2.3
Earnings per share 303.5 365.2 427.8 487.8 540.9 586.5
Dividend per share 113.9 122.6 128.7 135.2 141.7 148.7

Some hypotheses included in the aforementioned forecasts are the following:

- It has been decided to make conservative forecasts of sales, operating costs and
replacement and maintenance investments in order to introduce a margin of safety in
the results obtained.
- The replacement and maintenance investment amounts to 3% of the gross fixed assets
of the previous year and is necessary to preserve the company's competitive position
in its current situation.
- The disbursement in fixed assets of the new project, for an amount of 1,600 million,
will be made in 2019.
- The growth of operating working capital will follow a trend similar to the expected
increase in sales.
- The short-term net debt corresponds to the difference between the short-term debt
and the cash surplus. If it was negative it would mean that there is excess cash.
- The annual amortization is 5% of the gross fixed assets of the previous year.
- Operating costs on sales will remain at the 74.1% expected for 2018.
- The financial result is calculated by applying an interest rate of 7% to the average net
debt, obtained as a difference between the total debt and the excess cash.
- The growth of the dividend per share will be 5% per year, in accordance with the policy
established by the Board.
If the investment under study was not made, the firm’s growth would be limited to 4%
per year. Likewise, it is estimated that the competitive advantage provided by the new
investment will be diluted as of 2024 by the foreseeable reaction of the competition.
Therefore, the growth of the company from that year will be limited to 4% of the
proposed investment, unless the company undertakes new actions not yet identified.
Guidelines for the discussion:
1. Recent evolution and current situation of Kendal
2. Cost of the sources of funds.
3. Impact on the financial situation of the firm.
4. Firm value in each scenario.

CASE 6: Capital structure: bankruptcy costs

Brussels Ltd. is a firm about which we have the following financial information:

Number of shares 1,500

Stock price 1,000
Bonds 2,000,000
Interests 120,000
EBIT 700,000

The corporate tax rate is 40%. The debt is not risk-free but generates a default
likelihood whose present value is 80,000 + (D2/12,000,000). These bankruptcy costs only
arise when the debt-to-equity ratio is over 25%.

1. What would be the optimal amount of debt that maximizes firm value?

2. What would happen if the bankruptcy costs arose when the ratio is over 50%?

CASE 7: Capital structure: options approach

Berna Ltd. is a company dedicated to rail transport in large cities. In recent years,
it has experienced high growth, being considered one of the most dynamic urban
transport companies. At present, its assets are valued at 1,500 million euros. The
forecasts for next year are conditioned by the uncertainty about the licensing to operate
in new cities and market conditions. Specifically, the firm has estimated that if market
conditions are favorable, its value would increase by 100% next year. On the contrary,
in the unfavorable case, its value would fall by 50%. The most reliable business statistics
have estimated that the probabilities corresponding to both scenarios are 40% and 60%
respectively.
 To date Berna had been financed solely with shares, whose systematic risk
coefficient was 1. At the present time, the firm has decided to substantially modify its
financial policy by issuing a one-year loan with which it has bought part of the shares.
We know that the principal repayment value plus interest of the debt amounts to one
billion, that the risk-free interest rate is 5%, that the expected market return is 10% and
that the markets are in equilibrium.

Guidelines for discussion:

1. What is the market value of the firm equity after debt issuance?
2. What is the effective return rate of debt?
3. What is the debt beta coefficient?
4. What is the equity beta coefficient?
5. What is the firm (assets) beta coefficient?

CASE 8: Capital structure: options approach (II)

Dublin Ltd. is a firm whose asset is valued at 300 million euros. To finance this
asset, it has issued 75 million shares worth one euro each and a loan of 225 million bonds
(one euro each bond) that expires in one year with a repayment value of 231.75 million
euros. The risk free interest rate is 3 %. The company is in full international expansion,
which is why at the end of next year the value of its assets will be either 400 million
euros or 225 million euros with probabilities of 0.8 and 0.2 respectively.

1. How much would you pay for each of the bonds in the present moment?

2. How would these calculations be modified if the value of the asset varied between 500 and
180 million?

3. What if the company had financed 150 million shares and 150 million obligations both with
a nominal value of one euro? Then, the repayment value of debt would be 154.5 million
euros.

4. What if the variation in the value of the asset in section 2 was added to the capital structure
of the previous section?
CASE 9: Capital structure: The cost of capital
The capital structure of Prague, Ltd. consists of 400 million euros of debt that are long-
term bank loans at 7.5% interest, and 600 million euros of equity. The firm has 40 million
outstanding shares that are currently traded at 12 euros. The earnings before interest
and taxes are 100 million. The company distributes 50% of the net earnings as a dividend
and the tax rate is 40%.

The CEO of the firm studies different ways to fund the next expansion. One of them
would be the issuance of perpetual bonds amounting to 10 million euros, with a face
value of 100 euros each at 6% interest. Issuance expenses would amount to 5% of the
face amount of the securities. If the needs of debt exceeded that amount, the firm would
borrow a loan whose effective interest rate would be 9.5%. The second option would be
an equity offering by issuing shares of the same face value as the old ones, but with an
issuance premium of 10%. The issuance costs would be one euro per share.

How would the cost of capital function look like?