Earnings at Zombie Inc., a manufacturer of
Voodoo dolls for medicinal purposes, have suffered from competition
from lower-cost Asian remedies in recent years. The private company now
faces a turning point, as a result of its possible inability to repay a
principal repayment on its debt coming due in the next quarter.
The company's summary balance sheet is as follows:
| Assets |
|
|
|
Liabilities |
|
|
|
| Cash |
|
|
100000 |
Accounts payable |
|
1000000 |
| Accounts
receivable |
|
900000 |
Short term secured debt |
100000 |
| Other
short term assets |
5100000 |
Long term bank debt |
|
9000000 |
| Property,
plant and equipment |
8000000 |
Shareholders equity |
|
4000000 |
| Total |
|
|
14100000 |
Total |
|
|
14100000 |
The company's pro-forma annual cash flow is shown below:
| Earnings before interest and
taxes |
700,000 |
(up 2.5%
year-on-year)) |
|
| Interest |
|
|
|
990000 |
|
|
|
|
| Earnings
before taxes |
|
-290,000 |
|
Debt/Total Capital |
0.72 |
| Taxes |
|
|
|
0 |
|
-
Industry D/C |
0.25 |
| Earnings
after taxes |
|
|
-290,000 |
|
EBITDA Interest Coverage |
1.11 |
| Depreciation |
|
|
400000 |
|
-
Industry IC |
2.7 |
| Principal
repayment |
|
|
550000 |
|
|
|
|
| Cash flow |
|
|
|
-440,000 |
|
|
|
|
The company has had a merger proposal from a rival. The
potential acquirer would pay in shares at a price that values Zombie at
20% less than its book value. Management, however feels that the
company is worth at least 2x book and has made a restructuring proposal
to its unsecured bank lenders, namely that they convert one half of
Zombie's bank debt into equity at the current book value per share.
Other facts about Zombie, Inc.:
| Shares outstanding |
|
|
400000 |
|
| Share value |
|
|
$20 |
(management estimate) |
| Average beta of industry |
|
1.45 |
(based on alternative medicine
industry) |
| Interest rate on debt |
|
|
11% |
|
| Market price of debt, % of face |
|
80% |
(bank estimate) |
| Debt amortization rate (average) |
|
20 |
years |
| Tax rate |
|
|
|
35% |
|
| Treasury bond rate |
|
|
4% |
|
| Interest Coverage and Estimated
Rating |
|
|
|
|
| EBITDA interest coverage for smaller and
riskier firms: |
|
|
From
|
to |
Rating
is |
Spread
is |
| -100000 |
0.50 |
D |
14.00% |
| 0.5 |
0.80 |
C |
12.70% |
| 0.8 |
1.25 |
CC |
11.50% |
| 1.25 |
1.50 |
CCC |
10.00% |
| 1.5 |
2.00 |
B- |
8.00% |
| 2 |
2.50 |
B |
6.50% |
| 2.5 |
3.00 |
B+ |
4.75% |
| 3 |
3.50 |
BB |
3.50% |
| 3.5 |
4.50 |
BBB |
2.25% |
| 4.5 |
6.00 |
A- |
2.00% |
| 6 |
7.50 |
A |
1.80% |
| 7.5 |
9.50 |
A+ |
1.50% |
| 9.5 |
12.50 |
AA |
1.00% |
| 12.5 |
100000.00 |
AAA |
0.75% |
Questions:
1. What is the effect of the proposed equity-for-debt swap on Zombie
Inc.'s cash flow, and on its
leverage ratios?
2. If the banks agreed to the swap, what effect would this have on
Zombie's debt rating, beta and cost of capital?
3. Will shareholders be better off simply selling the company at 80% of
book?
|
