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Risk-free rate (exhibit 13) 8.50% 8.50% Price/ earnings (12x) $11.00 $19.80
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5/8/2012
Trade off between two financing Trade off between two financing
strategy strategy
Flexibility: Risk
◦ Equity financing provide greater flexibility over debt ◦ Downturn in the economy would reduce the cash flow
financing during the strike, rise in cost, loss of revenue due from operation
to strike in major buyers like Giganto and Brasilia Metal ◦ Reduced capital spending and managed working capital and
◦ Evident in the excess cash in the firm in 2002 under the receivables can help weather the storm
heading notes payable shows, firm has excess cash $2.7 ◦ However below certain point, financing by debt is inferior
million under debt alternative compared to $7.37 under to equity
equity alternative
◦ EBIT/EPS can be good ratio to measure the impact
Trade off between two financing Trade off between two financing
strategy strategy
EBIT/EPS Relationship for 1997
$7.00
Debt Financing Alternative Equity Financing Alternative $6.00
$5.00
EBIT (1997) $1.00 $2.00 $3.00 $4.00 $1.00 $2.00 $3.00 $4.00 $4.00
$3.00
Interest $2.00
EPS
$1.00
Old $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.74 $0.00
($1.00)
New $0.98 $0.98 $0.98 $0.98 $0.00 $0.00 $0.00 $0.00 ($2.00)
($3.00)
Profit before taxes ($0.72) $0.29 $1.29 $2.29 $0.26 $1.26 $2.26 $3.26 $1.00 $2.00 $3.00 $4.00
Taxes (at 0.34) ($0.24) $0.10 $0.44 $0.78 $0.09 $0.43 $0.77 $1.11 EBIT (millions)
Debt Financing Alternative Equity Financing Alternative
Net income ($0.47) $0.19 $0.85 $1.51 $0.17 $0.83 $1.49 $2.15
Within range of EBIT given in the case (3 – 6 million) debt
Number of shares dominates equity
(millions) 0.233 0.233 0.233 0.233 1.066 1.066 1.066 1.066 Point of indifference is at EBIT of $1.988mm, 42% below the
Earnings per
share ($2.03) $0.81 $3.64 $6.47 $0.16 $0.78 $1.40 $2.02
projected 1997 EBIT of $3.45
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5/8/2012
Trade off between two financing Trade off between two financing
strategy strategy
Income (or value) Timing
◦ Debt alternative gives higher value than by equity ◦ The Meryal Index has been rising but for company like
alternative Rosario with not so strong financial history, current
Control market might not be conducive for IPO
◦ Issue of common stock will dilute the current owners ◦ As suggested in exhibit 13, with declining interest
interest by nearly 88% rate, debt might be easy to sell.
◦ Voting control of Pablo Este will dilute from 58% to 13% Other
◦ Under debt option, control is diluted by only 15% - 25% ◦ Este and his investment partners would like to increase
through warrants the marketability of their common shares in Rosario. An
IPO would materially meet his aim