Rosario Acero SA Case Study

Question 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 companys 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

2002. With the issue of debt, it is reasonable to increase the EPS because number of shares outstanding
will remain constant. On the contrary, with the issuance of equity shares, though it is increasing trend but
less than in terms of debt issuance. Keeping other things constant, debt issuance could add value to the
firm through high EPS.
2. ROA (Return on Assets):
ROA under Private Placement with Warrants
1996

1997

1998

7.93%

4.06%

1996
7.93%

1999

2000

2001

2002

4.60%
5.16%
5.70%
ROA under Equity Shares

6.24%

6.76%

1997

1998

1999

2000

2001

2002

6.44%

6.93%

7.43%

7.91%

8.38%

8.84%

ROA of any firm is a measure of profit per dollar of assets. It is obtained by dividing net income by the
total assets of the firm. From the above calculation, 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.
3. ROE (Return on Equity):
ROE under Private Placement with Warrants
1996

1997

1998

49.0%

24.3%

1996
49.0%

1999

2000

2001

2002

22.8%
21.6%
20.5%
ROE under Equity Shares

19.5%

18.6%

1997

1998

1999

2000

2001

2002

14.2%

14.1%

14.0%

13.8%

13.7%

13.5%

ROE is a measure of how the stockholders fared during the year. ROE is, in an accounting sense, the true
bottom line measure of performance. It is calculated by dividing net income by the total equity of any
company. We can see that, with the use of either debt or equity does not have any greater effect on ROE.
Instead, in both the cases ROE has decreased in comparison to the ROE of 49% of the year 1996.
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 3: What are the principal risks the firm faces? Under some reasonable downside scenario, could
Rosario Acero continue to service its debt?

The principal risks that Rosario Acero S.A. 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
1.41
(1.71)
0.58

1998
1.20
(1.68)
0.57

1999
1.33
(1.63)
0.55

2000
1.46
(1.56)
0.53

2001
1.61
(1.48)
0.50

2002
1.78
(1.38)
0.47

0.29

0.09

0.25

0.43

0.63

0.87

2003
1.96
(1.39)
0.47
(1.88)
(0.83)

2004
2.16
(1.52)
0.52
(5.63)
(4.46)

The above table shows that if Acero takeas on a private placement of eight-year notes, the cash flows are
not enough to cover the payments of principal in year 2003 and 2004. As a result equity holders are
provided with negative free cash flows. Therefore, the firm will need to make arrangements for
refinancing for meeting the principal payment obligation.
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. The image of Acero will be deteriorated if the supplier is not able to
supply. As a result, Acero will lose its customers and sales.
Market fluctuation risk: The stock market of Argentina is tied up with South American markets. So, the
volatility in South American markets can harm the Argentinas market.(Example: Mexican peso crisis had
harmed the Argentinas market back in 1994)
Strong covenant risk: The debt covenants require Rosario Acero to maintain its EBIT coverage of at least
2.0. This could be a greater risk for the firm in reaching the level of EBIT.
In the case of reasonable downside scenario, the real GNP grows only by 1.5% with an inflation rate of
2.5%, yielding a real GNP growth rate of 4%. The forecast for annual rates of inflation is between 2.5%
and 4% and for Real Gross National Product (GNP) is 1.5% to 6%.
Rosario Acero financial statements projections have been based on a revenue growth rate of 10.3%. Lets
assume that the sales projections have been based on optimistic forecasts of the economys growth. As
per an optimistic projection, GNP growth rate will be 10%. ( 6% real GNP growth +4% inflation). From this
we can inferred that when GNP growth rate = 4%, sales growth rate =4.12% on the basis of GNP growth
rate= 10%, sales growth rate =10.3%

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%,
Sales growth rate of 4.21%

Revenues
Cost of Goods Sold
Selling, Generall, & Admin.
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. Item
Earnings per Share
EBIT/Interest

Actual Projected
1996
1997
34.80
36.23
-27.65
-28.26
-3.96
-4.71

1998
37.73
-29.43
-4.90

1999
39.28
-30.64
-5.11

2000
40.90
-31.90
-5.32

2001
42.58
-33.22
-5.54

2002
44.34
-34.58
-5.76

3.19

3.26

3.40

3.54

3.68

3.83

3.99

-1.10

-0.65
-0.98
1.63
-0.56
1.08

-0.55
-0.98
1.87
-0.64
1.24

-0.42
-0.98
2.14
-0.73
1.41

-0.27
-0.98
2.43
-0.83
1.60

-0.12
-0.98
2.74
-0.93
1.81

0.06
-0.98
3.08
-1.05
2.03

4.63

5.30

6.07

6.89

7.77

8.71

2.00

2.23

2.54

2.95

3.51

4.36

2.09
0.00
2.09
1.76
7.57
2.90

From the table, it can be seen that Acero would still have ability to continue servicing its debt under the
downside scenario (sales growth rate of 4.21%)
Question 4: From Rosarios standpoint, are the terms of the notes and warrants package competitive
and/or attractive?
Rosario Acero S.A had been planning to issue senior notes with non detachable warrants; notes being
issued at interest rate of 13% per annum payable semi-annually. The case also gives the base lending rate
in the economy as 8.5% plus 2%. Hence looking it from the companys perspective, the notes are not
attractive as the Rosarios coupon rate is 2.5 % higher than the base rate. Although this seems attractive
from investors perspective, it is not from the standpoint of the company. As also highlighted in Exhibit 14;
many companies in the similar industry are issuing debt at a rate higher than Rosario SA.
Further, the terms and conditions of issuance prohibit the company to redeem it before maturity. That is
the company cannot call the notes before 7th year. Such terms and conditions although protects the
potential investors from increasing interest rate risk, it will not allow the company to take the advantage
of potential decline of interest rate in the economy.
Warrants is a certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a
specific amount of securities at a specific price, usually above the current market price at the time of
issuance, for an extended period, anywhere from a few years to forever. In the case that the price of the
security rises to above that of the warrant's exercise price, then the investor can buy the security at the
warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain
unused.

Generally, the attachment of warrants with the notes is viewed as a sweetener which increases the returns
for the investors. The inclusions of warrants also benefit the company as it helps to reduce the coupon
payments in the notes. But this is not the same in the given case. The inclusion of warrants has no changes
in the companys coupon rates. The notes were being issued at high coupon rates of 13. Similarly, issue of
warrants with notes threatens the existing shareholders position in the company, which might get diluted
if the warrants are exercised.
Question 5: 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 companys offered value.

Question 6: 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 firms 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 managements 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 Rosarios 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
Levered Beta
D/E ratio
Tax rate
Multiplier
Unlevered Beta
Avg. Unlevered Beta
Real growth
Inflation
Nominal Growth rate
Rosario
Unlevered Beta

1997
0.7947

AD
1.35
0.7165
0.34
1.4729
0.9165
0.79477

CSA
1.05
1.5529
0.34
2.0249
0.5185

GA
1.00
0.4444
0.34
1.2933
0.7732

VAZ
1.15
0.2797
0.34
1.1845
0.9708

0.06
4%
0.1024
1998
0.7947

1999
0.7947

2000
0.7947

2001
0.7947

2002
0.7947

D/E ratio
Multiplier
Levered Beta
Risk free rate
Risk Premium
Re

1.1984
1.7909
1.42339
5.7%
4.54%
0.1216

1.0315
1.6808
1.3358
5.7%
4.54%
0.1176

0.8827
1.5826
1.2577
5.7%
4.54%
0.1141

0.7503
1.4952
1.1883
5.7%
4.54%
0.1110

0.6330
1.4178
1.1267
5.7%
4.54%
0.1082

0.5289
1.3491
1.0722
5.7%
4.54%
0.1057

D/A
0.4549

0.4922

0.5312

0.5713

0.6124

0.6541

0.5451

0.5078

0.4688

0.4287

0.3876

0.3459

0.1216
0.105

0.1176
0.105

0.1141
0.105

0.1110
0.105

0.1082
0.105

0.1057
0.105

0.0978

0.0938

0.0903

0.0872

0.0844

0.0819

E/A
Cost of
equity
Cost of
debt
WACC

Average
WACC
0.0892
1997

1998

1999

2000

1.4135

1.2017

1.3255

1.4620

Free Cash Flow

Discounted FCF

FCF 2002
1.7787
6%
0.0892
Value of all future FCFs on
2002
PV of all future FCFs

64.5031
38.6246

PV of Rosario on 1996 (end)

Rosario's total liabilities in
1996
Value of Rosario's equity in
1996
No. of stock outstanding
Fair price per share

2002
1.7787

1.0518
1.2977

Assumed growth rate

WACC

2001
1.6126

45.1164
22.8

22.3164
233000
95.7784

1.0129

1.0257

1.0386

1.0651

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. Unlevered Beta

Rosario
Unlevered Beta
D/E ratio
Multiplier
Levered Beta

AD

CSA
1.35
0.7165
0.34
1.4729
0.9166

1997
0.7948
4.9788
4.2860
3.4064

GA

1.05
1.5529
0.34
2.0249
0.5185

1998
0.7948
3.9618
3.6148
2.8729

VAZ

1.00
0.4444
0.34
1.2933
0.7732
0.7948

1999
0.7948
3.1901
3.1055
2.4681

1.15
0.2797
0.34
1.1846
0.9708

2000
0.7948
2.5947
2.7125
2.1558

2001
0.7948
2.1276
2.4042
1.9108

2002
0.7948
1.7556
2.1587
1.7157

Real growth
0.06
Inflation
4%
Nominal Growth 0.1024
rate

Risk free rate

Risk Premium

0.057
0.0454

Re

0.057
0.0454

0.2117

0.057
0.0454
0.1691

0.1874

D/A

0.057
0.0454
0.1549

0.057
0.0454
0.1438

0.2387
0.1673

0.2015

E/A
0.7985

0.2117

0.1874

Cost of equity

0.2782

0.3197
0.6371

0.7218

0.6803

0.1549

0.1438

0.1691

Cost of debt

0.1349

0.1302
0.1288

0.1293

0.1905

0.1669

WACC

0.1349

0.3629

0.7613
0.8327

0.057
0.0454

0.1370
0.1315

0.1336

0.1359

0.1260
0.1479

0.1492

0.1187

Average WACC

Working notes:

Amount
Percentage of total debt
Cost

1997
$6.66
47%

1998
$6.39
46%

Old Debt
1999
2000
$5.92
$5.23
44%
41%
0.105
New debt

2001
$4.29
36%

2002
$3.06
29%

Amount
Percentage of total debt
Cost

1997
7.50
53%

1998
7.50
54%

1999
7.50
56%
0.13

2000
7.50
59%

2001
7.50
64%

2002
7.50
71%

1997

1998

1999

2000

2001

2002

Free Cash Flow

1.4135

1.2017

1.3255

1.4620

1.6126

Discounted FCF

1.2314

0.9120

0.8764

0.8421

0.8092

FCF 2002
Assumed growth rate
WACC
Value of all future FCFs on
2002
PV of all future FCFs

1.7787

PV of Rosario on 1996 (end)

Rosario's total liabilities in
1996
Value of Rosario's equity in
1996
No. of stock outstanding
Fair price per share

6%
0.1479
21.4572
9.3804
14.8292
22.8
(7.9708)
273000
(29.1972)

1.7787
0.7776

Annex 3: Calculation of Fair price of share under different assumptions

Peer Firms
Levered Beta
D/E ratio
Tax rate
Unlevered Beta

AD
1.35

CSA
1.05

GA
1.00

VAZ
1.15

0.7165
0.34

1.5529
0.34

0.4444
0.34

0.2797
0.34

0.916552872

0.518534

0.773196

0.970808

Avg. Unlevered Beta

Rosario
Unlevered Beta
D/E ratio

0.794772535

1997
0.794772535
1.1984

1998
0.794773
1.0315

1999
0.794773
0.8827

2000
0.794773
0.7503

2001
0.794773
0.6330

2002
0.794773
0.5289

Levered Beta

1.42339176

1.335861

1.257768

1.18836

1.12679

1.072203

Risk free rate

Risk Premium

0.057
0.0454

0.057
0.0454

0.057
0.0454

0.057
0.0454

0.057
0.0454

0.057
0.0454

Re

0.121621986

0.117648

0.114103

0.110952

0.108156

0.105678

D/A
E/A
Cost of equity
Cost of debt
Cost of debt (after tax)

0.454876803
0.545123197
0.121621986
0.105
0.0693

0.49224 0.531165 0.571319 0.612386 0.654069

0.50776 0.468835 0.428681 0.387614 0.345931
0.117648 0.114103 0.110952 0.108156 0.105678
0.105
0.105
0.105
0.105
0.105
0.0693
0.0693
0.0693
0.0693
0.0693

WACC

0.097821928 0.093849 0.090305

Average WACC

0.087155 0.084361

0.081884

0.089229491

Free Cash Flow

Discounted FCF

1997
1.413478032
1.297686157

FCF 2002
Assumed growth rate
WACC
Value of all future FCFs on 2002
PV of all future FCFs

1.778672702
0.06
0.089229491
64.50311068
38.62462818

PV of Rosario on 1996 (end)

Rosario's total liabilities in 1996 (end)
Value of Rosario's equity in 1996
(end)

45.11636282
22.8
22.31636282

1998
1.201694
1.012873

1999
1.325469
1.025679

2000
1.461992
1.038646

2001
1.612577
1.051777

2002
1.778673
1.065074

No. of stock outstanding

Fair price per share

233000
95.77838118
Assumption: FCF after 2002 grows at 6%

Hence, 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

Class Answers
What is the problem with the company?
Wanted capital but didnt know how to raise it
Need the capital because in 93, 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. Why is Rosario considering obtaining long term capital
a. Expansion gone through teething stages of breaking away from parent
b. Further growth needs more capital capital intensive industry
2. How will the two financial alternatives affect the performance of the firm?
3. What are the principal risks the firm faces?
4. Are the terms of the notes and warrants package competitive and/or attractive?
5. As for the possible equity issue, would an offering price of $9 per share be fair?
6. Which course of action should Este adopt?
Mix of classes of capital
1996
1994
Liabilities/equity
6.3
28.6
(debt+notes)/equity
4.1
EBIT/interest
2.9
1.8
EBIT/(interest + amort)
1.9
The debt ratio is still high, 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, 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. Economic environment could be right due to trade union. Debt
reduces flexibility. Owners want liquidity of their investment through a share option