Rosario Acero SA Case Study

Question : 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 : 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.

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. The competitors are Acero Dali S.A. (AD), Colon S.A. (CSA), Greco Acero (GA), and
Velasguez S.A. (VAZ). We have not considered Picasso Acero S.A (PI) to calculate the unlevered beta,
since this company is going through losses in the most recent years.
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. With the use of unlevered beta of competitors, Rosarios levered
beta has been calculated. The same levered beta, with addition to risk free rate of 5.7% (3-month T-bill rate,
case Exhibit 13), and risk premium of 4.54%, has been used to come up with return on equity (R e) for the
firm by using equity as an alternative. We found risk premium by calculating nominal growth rate and
deducting risk free rate from this nominal rate. We have assumed that the stock price grows with the growth
in economic activity such as GDP (6%). With the use of various cost of equity in each year from 1997-1998,
and a constant cost of debt of 10.5% (Exhibit 14), we have computed the WACC (Weighted Average Cost
of Capital) for the company in each year. Then, these WACC has been averaged and used to discount the
free cash flow in each year. Finally, we come up with the fair price per share of $95.77 for the Rosario's
stock. (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. The only difference is the use of cost of debt as the proportion of old as well as new debt. So
in this case the cost of debt varies in each year. There is different WACC in this case which has been used to
discount the forecasted cash flow. The fair price of stock comes to be a negative $29.20 if firm uses a debt
with warrants financing. (Calculation in Annex 2)

Question : As for the possible equity issue, 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.
We are not provided with clear information regarding expected growth. So, we have assumed the growth
rate to be 6%. It is assumed that the stock market reflects the economy, but we have included the impact of
inflation rate as 4% in our computation.

By sticking with this assumption we compute the fair value for Rosario. The fair value for the company is
$95.78 which is quite higher than the company’s offered value.

Question : Which course of action should Este adopt? In preparing your recommendation, use the
FRICTO framework to identify the trade-offs between the two alternatives. (FRICTO stands for
flexibility, risk, income, control, timing, and other.)

From our analysis we have come to find that , the offer (IPO) price of $9 per share of Rosario stock
would much lesser than its fair (intrinsic) price of $95.77. Similarly, Rosario's intrinsic equity value will
be negative by $29.19 per share if the new debt with warrants is used as a financing option. So we have
decided to g for IPO rather than short notes with warrants.

The FRICTO analysis is as follows:

 Flexibility: When warrant is used the it may use up the firm’s debt capacity, thus precluding debt as
a financing option in future years to meet the firms anticipated future financing requirements. .
Sometimes the need for additional capital in the future is for unforeseen reasons, such as a sudden
investment opportunity or a financial crisis due to a severe economic downturn. So issuing warrants
does not provide flexibility to the company. But issuance of IPO would be more flexible. The EPS
produced are forecasted to be higher and the firm would maintain most of its flexibility due to it. By
becoming a publicly traded company a business can take advantage of new, larger opportunities and
can start working towards incorporation and even worldwide expansion. IPO gives a company fast
access to public capital. Even though public offering can be costly and time consuming, 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 more investors wish to invest in a company, the more the company stands to
or from IPOs and other stock offerings. The risk associated with debt is less than that associated with
equity financing ”. If one plans on exercising the warrant he must do so before the expiration date.
The more time remaining until expiry, the more time for the underlying security to appreciate, which,
in turn, will increase the price of the warrant (unless it depreciates).

 Income: For the investor, IPOs are attractive mainly because they may be undervalued. Initially, to
make IPOs more attractive, many companies will offer their initial public offering at a low rate. This
helps to encourage investors, and investors will often buy IPOs, thinking that the new company or
the newly public company will be the next big thing with a huge profit margin. As prices grow and
demand for the IPOs grows, early investors stand to make a lot of profit -- and very quickly. So IPOs
are good sources of income. Because no additional interest is paid, common stock financing always
produces higher earnings after taxes than debt. However, debt financing usually (although not always
under all conditions) produces higher ROE and EPS.

If interest rates increase after Rosario issues the bonds, Rosario would be set in on a fixed lower rate,
which means that they would need to pay out less each period to its bondholders. However, 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. Overall, the debt financing option seems
better for Rosario Acero.

 Control: The forecasted higher EPS also helps the firm not give up its control. Issuance of warrant
does not give the warrant holders voting rights whereas that of IPOs gives the shareholders the
voting rights. In this case warrants might have better benefit in terms of the management’s control
over the firm.

 Timing: As the case describes that the economy of the country has been gaining better heights after
the Mexican Peso crash. the stock market had rebounded from the Tequila effect of the Peso crash.
The Merval index has risen over the previous three years, suggesting a growing optimism among the
equity investors in Argentina .The market of IPO seemed to be rising though the volume is still low
comparatively. Under such circumstances issuance of IPO would have better tradeoff than warrants.
Further, debt financing might require high interest payments. Moreover, most of the companies
issuing debts in South America have been rated below investment grade. Due to this fact too it would
not be wise to go for debt financing.

 Other: Pablo Este himself is concerned about the liquidity of his investments in the firm. He along
with the other equity investors feels the need to increase the marketability of Rosario’s common
stock. Under such circumstances it would be better to go for IPO as well.

Annex 1:

Computation of fair price of stock using Equity financing

Competitors AD CSA GA VAZ
Levered Beta 1.35 1.05 1.00 1.15
D/E ratio 0.7165 1.5529 0.4444 0.2797
Tax rate 0.34 0.34 0.34 0.34
Multiplier 1.4729 2.0249 1.2933 1.1845
Unlevered Beta 0.9165 0.5185 0.7732 0.9708
Avg. Unlevered Beta 0.79477

Real growth 0.06

Inflation 4%
Nominal Growth rate 0.1024

Rosario 1997 1998 1999 2000 2001 2002

Unlevered Beta 0.7947 0.7947 0.7947 0.7947 0.7947 0.7947
D/E ratio 1.1984 1.0315 0.8827 0.7503 0.6330 0.5289
Multiplier 1.7909 1.6808 1.5826 1.4952 1.4178 1.3491
Levered Beta 1.42339 1.3358 1.2577 1.1883 1.1267 1.0722
Risk free rate 5.7% 5.7% 5.7% 5.7% 5.7% 5.7%
Risk Premium 4.54% 4.54% 4.54% 4.54% 4.54% 4.54%
Re 0.1216 0.1176 0.1141 0.1110 0.1082 0.1057

D/A
0.4549 0.4922 0.5312 0.5713 0.6124 0.6541
E/A
0.5451 0.5078 0.4688 0.4287 0.3876 0.3459
Cost of
equity 0.1216 0.1176 0.1141 0.1110 0.1082 0.1057
Cost of 0.105 0.105 0.105 0.105 0.105 0.105
debt
WACC
0.0978 0.0938 0.0903 0.0872 0.0844 0.0819
Averag
e 0.0892
WACC

1997 1998 1999 2000 2001 2002

Free Cash Flow 1.41 1.2
1.325 1.462 1.612 1.778
35 017 5 0 6 7
Discounted FCF 1.29 1.0 1.025 1.038 1.051 1.065
77 129 7 6 8 1

FCF 2002
1.7787
Assumed growth rate 6%
WACC
0.0892
Value of all future FCFs on
2002 64.5031
PV of all future FCFs
38.6246

PV of Rosario on 1996 (end)

45.1164
Rosario's total liabilities in 22.8
1996
Value of Rosario's equity in
1996 22.3164
No. of stock outstanding 233000
Fair price per share
95.7784
Annex 2:
Calculation of fair price per share using debt with warrant financing
Peer Firms AD CSA GA VAZ
Levered Beta 1.35 1.05 1.00 1.15
D/E ratio 0.7165 1.5529 0.4444 0.2797
Tax rate 0.34 0.34 0.34 0.34
Multiplier 1.4729 2.0249 1.2933 1.1846
Unlevered Beta 0.9166 0.5185 0.7732 0.9708
Avg. Unlevered Beta 0.7948

Rosario 1997 1998 1999 2000 2001 2002

Unlevered Beta 0.7948 0.7948 0.7948 0.7948 0.7948 0.7948
D/E ratio 4.9788 3.9618 3.1901 2.5947 2.1276 1.7556
Multiplier 4.2860 3.6148 3.1055 2.7125 2.4042 2.1587
Levered Beta 3.4064 2.8729 2.4681 2.1558 1.9108 1.7157

Real growth 0.06

Inflation 4%
Nominal Growth 0.1024
rate

Risk free rate 0.057 0.057 0.057 0.057 0.057 0.057

Risk Premium 0.0454 0.0454 0.0454 0.0454 0.0454 0.0454
0.211 0.1 0.169 0.154 0.143 0.134
Re
7 874 1 9 8 9

D/A 0.1 0.2 0.238 0.27 0.319 0.362

673 015 7 82 7 9
E/A 0.8 0.7 0.761 0.72 0.680 0.637
327 985 3 18 3 1
Cost of equity 0.2 0.1 0.169 0.15 0.143 0.134
117 874 1 49 8 9
Cost of debt 0.1 0.1 0.130 0.13 0.133 0.137
288 293 2 15 6 0
WACC 0.1 0.1 0.149 0.13 0.126 0.118
905 669 2 59 0 7
Average WACC 0.147
9

Working notes:
Old Debt
1997 1998 1999 2000 2001 2002
Amount $6.66 $6.39 $5.92 $5.23 $4.29 $3.06
Percentage of total debt 47% 46% 44% 41% 36% 29%
Cost 0.105
New debt
Amount 1997 1998 1999 2000 2001 2002
Percentage of total debt 7.50 7.50 7.50 7.50 7.50 7.50
Cost 53% 54% 56% 59% 64% 71%
0.13

1997 1998 1999 2000 2001 2002

Free Cash Flow 1.4135 1.2017 1.3255 1.4620 1.6126 1.7787

Discounted FCF 1.2314 0.9120 0.8764 0.8421 0.8092 0.7776

FCF 2002 1.7787

Assumed growth rate 6%
WACC 0.1479
Value of all future FCFs on
2002 21.4572
PV of all future FCFs 9.3804

PV of Rosario on 1996 (end) 14.8292

Rosario's total liabilities in
1996 22.8
Value of Rosario's equity in
1996 (7.9708)
No. of stock outstanding 273000
Fair price per share (29.1972)