Dr. P.V. Viswanath
points each) Read the following article and answer the questions below:
How could Miguet force creditors to make concessions?
Donít creditors have an iron-clad contract whereby the company
has to pay them a coupon and bond face value?
According to the Eurotunnel website, http://www.eurotunnel.com/ukcMain/ukcCompany/ukcInvestorRelations/ukcShareholderInfo/ukpShareholderAnalysis, as of Dec. 31, 2003, 6% of Eurotunnelís shares are hold by banks, 29% are held by institutions and 65% are held by individuals.
According to the Eurotunnel website, there was 6.4billion euros of debt, as of 12/31/03. Of this, 0.4b was senior debt, 4.5 was junior debt, 1.5 billion consisted of Participation Loan notes, while equity consisted of 1.1b euros.
The share price, as of March 13, 2005 was 0.24 euros.
PARIS -- Creditors of Eurotunnel, the struggling operator of the underwater "Chunnel" linking Britain and France, are bracing for tough negotiations with new management after the unprecedented ouster of the European company's two top executives and the rest of its board by a shareholders' revolt.
French politician and publisher Nicolas Miguet rallied shareholders around his own team of directors, promising to defend small investors and force creditors to make concessions in the restructuring of Eurotunnel's debt of GBP 6.4 billion ($11.8 billion), much of which is now held by hedge funds.
Mr. Miguet's campaign struck a chord with Eurotunnel's 1.1 million, mainly French, small investors whose shares have plummeted in value. At a shareholder meeting in Paris, 63% of investors voted to oust Chairman Charles Mackay, Chief Executive Officer Richard Shirrefs and the rest of the Eurotunnel board. They also voted for a new team of directors, including Jacques Maillot, former head of travel agency Nouvelles Frontieres, who is expected to become Eurotunnel's new chairman.
The move marked the first time shareholders tossed out the management of a listed company in France.
But while shareholders celebrated -- Eurotunnel shares rose 7% on the news in Paris -- creditors warned they won't give much ground to stockholders. The company has a market capitalization of GBP 1.4 billion, just one-fifth of debt outstanding.
While the new management has yet to detail its restructuring plans, bondholders think part of the rescue would involve swapping Eurotunnel debt for equity, a classic restructuring step. However, instead of wiping out shareholders, as would normally happen, they think the Eurotunnel rebels would like to save some equity for shareholders.
Whatever their stance, a new Eurotunnel management is under pressure to reach an agreement with creditors. The company will start to face a debt-repayment crisis at the end of next year, when it has to make all of its interest payments in cash, under the terms of the last debt- restructuring pact in 1997, said Markus Niemeier, research analyst at Barclays Capital in London.
2. (30 points) You wish to buy a car. Unfortunately, you donít have any ready cash. On the other hand, you just recently invested $200,000 in a private equity fund. The fund manager will not give you your money back right away, unfortunately. However, according to your calculations, your investment in the fund should grow at the average rate of 15% a year for the next 5 years, at the end of which you can cash out.
Of course, you still want your car right now! What to do? Luckily for you, your friendly banker is willing to lend you some money using your investment as collateral. Your banker believes that your investment has a beta of 1.5, the market risk premium is 6% and that the current five-year T-bond rate is 4.5%. He is willing to lend you 80% of the estimated market value of your investment so that you can buy your car. The APR on the loan is 18% and the money is to be repaid in monthly installments, starting 13 months from now. If there are 48 payments in all, what is the size of each payment?3. (5 points each) Read the article below and answer the following questions with full explanations:
DON'T LET A HIGH BETA dissuade you from buying an otherwise promising
Beta is a measure of volatility. It's based on a statistical comparison
of the fluctuations of a given company's share price versus the fluctuations of
an index -- usually the Standard & Poor's 500- stock index -- over a certain
time period. A stock with a beta of 0.5, for example, is said to be only half as
volatile as the S&P 500; a stock with a beta of 2.0 is doubly so. A stock
with a negative beta zags when the S&P 500 zigs.
Bearish and safety-first investors usually look for low-beta stocks --
those with betas of, say, 0.5 and lower -- because these have shown a tendency
to outperform the S&P 500 during broad market declines. But low-beta stocks
also tend to underperform during surges. So bullish or aggressive investors
might wish to search specifically for high betas.
The 10 stocks on the list below have betas of 2.0 or higher; that is,
they've shown at least twice the volatility of the S&P 500 over the past
three years. All have posted share-price gains of at least 12% over the past 26
weeks (again, about double that of the S&P 500), and have had their
current-year and next-year earnings consensuses boosted within the past four
weeks. All have topped earnings expectations, on average, in their past four
quarterly reports, and have debt/capital ratios of 0.4 or lower. Finally, all
are projected to boost their earnings by at least 12% annually over the next
To get an idea of how expensive each stock is relative to its growth
prospects, give its price/earnings-to-growth, or PEG, ratio a look. The measure
is calculated by dividing a company's price/earnings multiple by its projected
long-term earnings growth rate. Stocks with PEGs near or below 1.0, in
particular, are considered possible bargains.
As always, please research thoroughly any stocks on our list before
Volatility Is a Good Thing
These 10 stocks carry high betas as a result of their rapid price gains.
4. Philip Morris is examining the costs of equity and capital it uses to decide on investments in its two primary businesses Ė food and tobacco. It has collected the following information on each business:
∑ The average beta of publicly traded stocks in the tobacco business is 1.10 and the average debt/equity ratio of such firms is 20%.
∑ The average beta of publicly traded firms in the food business is 0.809, and the average debt/equity ratio of such firms is 40%.
Philip Morris has a beta of 0.95 and a debt ratio of 25%; the pre-tax cost of debt is 8%. The treasury bond rate is 7% and the corporate tax rate is 40%. The market risk premium is estimated to be 5%.
a. (10 points) Estimate the cost of capital for the tobacco business; also estimate the cost of capital for the food business.
b. (10 points) Estimate the cost of capital for Philip Morris, as a firm
c. (10 points) Having looked at your estimates of the cost of capital for the tobacco and food divisions at Philip Morris, the financial managers have come back with a question. Where, they want to know, does the substantial risk posed by tobacco lawsuits show up in the costs of capital that you have estimated? Respond.
Solutions to Midterm
1. a. Creditors do have a contract whereby the company has to pay them a coupon and bond face value. However, there are often provisions in bankruptcy law, whereby a company may be allowed to suspend payments to its creditors if doing so is necessary for the company to maintain itself as a going concern. The key word, here, is suspend. Once a company enters into bankruptcy there is a procedure in place, whereby the company has to be reorganized or liquidated. In principle, the creditors are not supposed to lose out at all; and the purpose of the suspension of payments is only supposed to prevent an unwarranted scramble for repayment on the part of creditors that might force an otherwise healthy company into bankruptcy -- this would be akin to a trading halt on an exchange, in a company's stock, if the price starts dropping precipitously because of investor panic.
However, where the bankruptcy law gives existing shareholders or existing management, discretion as to how to file the reorganization plans, bondholders might be willing to forego some of their rights or payments, in order to ensure a speedy conclusion to the bankruptcy proceedings. This is particularly important because the ability to wait is, in itself, a sort of call option that can only be beneficial to stockholders. European Law is, in general, not as debtor-friendly as US law; still the law there is also getting more debtor-friendly over time.
Finally, management can often take actions that expropriate bondholder value because no contract, least of all, a bond indenture, is complete.
b. In this case, even though a large percentage of the shares were diffusely held -- 65% -- still, 35% were held by banks and institutions, and so, only 16% more was needed from the shares held by individuals, in order to vote against the managemetn slate of candidates for the Board of Directors. It is also possible that even though 65% of shares were held by individuals, this percentage may not have been held diffusely -- in other words, there might have been some large blocks amongst the 65%.
2. The expected value of your investment in the private equity fund, after five years is 200,000(1.15)5 = $402,271.44. This investment has a beta of 1.5; hence the required rate of return on this investment is 4.5 + 1.5(6) = 13.5%, using the CAPM. Hence the market value of this investment is 402271.44/(1.135)5=$213,569.82. The banker will lend 80% of this, or $170,855.86. The APR on the loan is 18%; hence the effective monthly rate is 18/12 or 1.5%.
Payments, however, don't start until 13 months from now; so it is as if we have a loan that will be made in a year's time with monthly payments starting the next month. If we look at it, this way, the value of the loan, in 12 months time, rises to 170,855.86(1.015)12 = $204,278.37. We can, now, use the annuity formula to find the value of each of the 48 monthly payments, by solving 204,278.37 = (C/0.015)[1-(1/1.015))48] or C = $6000.68.
3. a. A stock with a beta of 0.5 is more than half as volatile as the
market portfolio, because in addition to market related uncertainty stocks
also have idiosyncratic volatility. Of course, this idiosyncratic volatility
does not "count" in terms of being priced by the market, but
it contributes to the volatility, nevertheless, if not to risk.
4. a. If Philip Morris desires to use its own debt ratio of 25% for all its business, then the computation of the levered beta to be used for its tobacco business is as follows: the unlevered beta for firms in the tobacco business is 0.982; lever up this using Philip Morris' debt ratio of 25% to get 1.1784. Hence the cost of equity is 7 + 1.1784(5.5) = 13.481. The cost of capital is (0.75)(13.481) + (0.25)8(1-0.4) = 11.31%.
The cost of capital for the food business is computed similarly. The unlevered beta for firms in the food business is 0.645; lever up this using Philip Morris' debt ratio of 25% to get 0.774. The cost of equity is 7 + 0.774(5.5) = 11.257%. The cost of capital is (0.75)(11.257) + (0.25)8(1-0.4) = 9.643%
b. It would make no sense to compute Philip Morris' firm cost of capital, since it is an arbitrary mix of different businesses. However, we could compute the average cost of equity for Philip Morris as 7 + 0.95(5.5) = 12.225, and the cost of capital as (0.25)(8)(1-0.4) + (0.75)(12.225) = 10.369%
c. One might argue that litigation risk is diversifiable, and should
not be included in the costs of capital.