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Armstrong Production Company a Study in Capital Structure

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    The Armstrong Production Company is an industry-leading firm in the field of manufacturing synthetic building materials for homes and commercial structures, based near St. Louis. Armstrong was fortunate in its initial stages to quickly secure inexpensive funding in the form of developmental loans issued by the State of Illinois, and thus was able to break even within three years of its founding in the early 1970s.

    Able to pour resources into its research and development segment, riding on the increasing demand for construction materials from the 1970s to 1980s, and issuing 15 million shares for the company in an initial public offering (20% of this is currently owned by the board of directors, with another 13% controlled through the company’s employee stock ownership plan). Armstrong Production was able to greatly expand without incurring an overwhelming amount of debt.

    Following the stock issue, debt composed only 10% of the firm’s capital structure, with equity (that is, money earned from issuing stocks and retaining earnings in the company) composing the rest. Wanting to diversify into consumer goods and furniture, as well as providing disincentive to opportunistic acquirers of companies with low debt, Armstrong’s board decided was persuaded to issue $145 million in bonds in the mid-1980s, after some hesitation concerning interest rates.

    The further expansion of the company proved a fiscally-sound decision, resulting in record annual earnings of $115 million in 1990. However, the next year, the construction boom of the last two decades came to an end and the construction materials industry contracted considerably, resulting in downsizing in many firms. Thanks to its push to diversify its products a few years earlier, Armstrong was able to weather the downturn relatively well, with earnings before taxes or interest stabilizing at about $85 million in 1996.

    Currently, the company’s debt is $110 million, composing approximately 25% of the firm’s capital structure. Several of Armstrong’s board members are concerned about the possibility of the firm going into bankruptcy and have discussed with Armstrong’s chief financial officer about lowering this debt level. Uncertain of future macroeconomic performance, the planning committee has developed the following three scenarios and their effect on the company’s earnings before interest and taxes (EBIT)… ProbabilityEBIT 0%$40 million 60%$85 million 20%$130 million The company’s stock currently trades at $22. 00 a share. While some within the Armstrong’s upper management want to use the company’s good reputation to issue more shares and reduce its debts, others want the company to buy back existing shares, though this would further increase the company’s debt. In any case, the company would be forced to refund all existing bondholders at par value if the company’s capital structure were modified by the exchange of debt and equity.

    Though the company may buy back shares, it has no plans to undertake new project requiring external funding, though some within the company (including its marketing vice president and second-largest shareholder) believe that such a cautionary stance is bad for business and that the company should either expand internally or should acquire subsidiaries, even if it means taking on further debt in order to do so.

    There are no specific suggestions as to what the nature of this expansion should be. Our team has been asked by Armstrong’s chief financial officer to analyze the company’s capital structure in time for the next annual board of directors meeting, and to educate those in attendance about capital structuring through hypothetical examples. Specifically, we are to discuss… 1. …The different types of risk and how risk is measured… 2. …How debt affects risk and return to the company… 3. The differences between on company financed with $400 million of equity, and one with $200 million of equity and $200 million of debt at 11%… 4. …How recapitalization alters stock price, number of shares of equity, weighted average cost of capital (WACC) and earnings per share (EPS)… 5. …How an increase or decrease in business risk alters the cost of capital, the optimal capital structure, and future budgeting decisions, and… 6. …How adding and paying off debt in various stages affects risk. For this we ill look at two scenarios in which $30 million at 10% is added to Armstrong’s existing debt, followed by either another load of debt of $100 million at 11% and using $30 million of that to pay off the previous debt issue and $70 million to buy back stock, or by simply adding another $70 million in debt without using it to pay off the previous $30 million debt issue. When analyzing capital structure, it is first important to understand what exactly what types of risk we need to identify. To clearly gain a full idea of how capital structure affects a business’s ability to stay in operation, we must identify its business and financial risks.

    A business risk is one which affects a company’s ability to pay for its operations – its wages, rent, utility bills, supplies, and the like. A financial risk is one which affects a company’s ability to repay creditors. Financial risk is closely tied to the amount of debt that a company has already assumed, as debt accumulates interest which must be considered and eventually addressed. On the other hand, business risk is not, in theory, affected by the amount of debt that a company owes, and therefore we will deal almost exclusively with financial risk for the remainder of our analysis.

    The central question that the Armstrong Productions Company is debating is whether additional debt financing is beneficial enough to be worth the risk that it entails. Thus we must be sure to understand how debt financing affects the cost of further debt and equity, which itself is related to the risk that a firm’s debt incurs. Generally speaking, the more debt and interest that a company incurs, the less likely it is able to address its debts and obligations in a consistent and timely manner, so the more expensive it becomes to finance additional debt or equity (mostly through increases in interest rates or demands for greater dividends.

    The credit rating of a firm, in particular, is a powerful determinant of the cost of further financing). We may possibly defray this added risk, however, if we use debt to buy back company shares (not only do we not have to pay interest on repurchased shares, but remaining investor’s holdings for will be more valuable and hopefully they may not demand more in the way of dividends) and take advantage of the increased interest expense as an enhanced interest tax shield (since interest expense represents a cut in our profits, we also acquire a decrease in our total amount of taxes).

    When analyzing the debt issue of a large corporation, it is important to consider the implications on that company’s share price. This is because it is common for companies to use newly acquired debt, either in part or in full, to buy back shares of their stock, usually for the purposes of management tightening control over the company’s ownership and to increase the value or price of remaining outstanding shares. Let us consider the Armstrong Production Company’s existing capital structure, composed of $110 million of debt at 11% and 15 million shares of outstanding stock, valued at $22 per share.

    Let’s say that Armstrong decides to issue additional debt, $200 million and also with an 11% interest rate, to purchase as many outstanding shares at the market price of $22 dollars each as possible. Under such conditions, Armstrong can purchase exactly 9,090,909 shares… $200 million / $22 per share value = 9,090,909. 091 shares (I’m being conservative and rounding down) So now there are only 5,909,091 shares remaining outstanding on the market. Also, our total debt is now $310 million. EBIT may remain the same before and after, and we can find the specific value for it, now that we have more numbers to work with.

    Since EBIT is earnings before and after tax, because we know our interest rates and debt levels, and because we don’t have to worry about taxes for this example, it’s possible to find the earnings per share of stock (EPS) and with that, EBIT. · Assuming EBIT is the same before and after change in capital structure… · EBIT=(# Shares*EPS)+Interest Expense from Debt · (# Shares Before*EPS)+(Debt Before*Interest on Debt)=(# Shares After*EPS)+(Debt After*Interest on Debt) · (15,000,000*EPS)+(110,000,000*0. 11)=(9,090,909*EPS)+(310,000,000*0. 1) · (5,909,091 EPS)=22,000,000 · EPS=$3. 72 With this information, we can figure out the EBIT that is the same for both the old and new capital structure… · (15,000,000*$3. 72)+(110,000,000*0. 11)? 67,900,000* · (9,090,909*$3. 72)+(310,000,000*0. 11)? 67,900,000* *Approximated to the sake of example. Actual results using rounded numbers are different As you can see, $67,900,000 is the minimum EBIT which Armstrong must earn if it is to buy back shares with debt under this scenario and increase (or at the very least, maintain) existing EPS.

    To test whether there is any advantage in debt financing after this indifference point, I have constructed the following graph. In terms of moral and legal obligations, among the most important of an executive’s duties is to increase value for shareholders, as measured in earnings per share (EPS). The above graph examines the effect on earnings per share of various EBIT levels. The red line represents our old capital structure (the one where debt stays at $110 million) and the green line represents the new capital structure (where debt increases to $310 million).

    We can see that the newer capital structure scheme increases shareholder value more quickly as EBIT increases, becoming as beneficial in terms of EPS as the old structure at an EBIT of $67,900,000. Beyond this, the new capital structure becomes more and more beneficial as EBIT continues to rise. The new capital structure will only benefit shareholders more and more as we move it beyond $67,900,000. This leverage is a strong motivation for Armstrong to at least consider taking on additional debt while increasing EBIT as high as it is prudently possible.

    There are, of course, disadvantages to taking on more debt, from increased interest expenses to decreasing investor confidence in the firm, as well as the fact that a company is more vulnerable to bankruptcy. Upper management must balance the benefits with the drawbacks of issuing new debt. Why does the capital structure with more debt produce a higher EPS? Well, when we issued debt, our objective from the beginning was to buy back outstanding shares. When we bought back some shares, there were less outstanding shares left on the market to spread our EBIT through.

    So even though we pay more interest-related expenses with additional debt, this is more than made up for by the increase in earnings per share. At a certain point, though, high enough interest would make EPS decrease to a lower level with high enough debt. The following graph tracks this relationship at an EBIT of $85,000,000 (our current and most likely future EBIT), which, at our pre-set interest rate of 11%, creates a higher EPS when we have more debt and less stock… Although the label makes it difficult to see, the intersection of the two capital structures is (0. 376, 4. 6575), meaning that beyond an interest rate of approximately 13. 76% on debt, it becomes better for EPS to finance the company with less debt at an EBIT of $85,000,000. This trend likely holds true for differing EBITs (of course, the exact numbers are different of course). The above chart also illustrates that higher interest on debt always results in lower EPS. Thus, securing a low interest rate is just as important to consider as is the amount of debt to acquire.

    While our debt load is only limited by the monthly interest that Armstrong Productions can safely manage to handle, increasing interest rates more quickly become disadvantageous, rapidly eating through or eliminating a company’s EBIT. To further illustrate the consequences of different capital structure, let us consider another hypothetical example: One firm is funded with 100% equity, in the form of $400 million worth of stock, while another is funded with $200 million of stock and $200 million of debt at 11% interest.

    In this exercise, we’ll look at the return on equity (ROE) and times interest earned (TIE) for EBITS of $40 million, $85 million, and $130 million (which have a 20%, 60%, and 20% chance of occurring, respectively). Both of the terms we were just introduced to are further explained below. ROE measures the return that a company’s equity manages to generate. A large ROE indicates that a company is using its equity well, while a low ROE means that a company isn’t using its equity effectively. ROE is measured by taking net income (after interest and taxes) and dividing that by shareholder quity. TIE is measured by taking EBIT and dividing it by total interest payable on debt. The higher TIE is, the less trouble a company is predicted to have in paying its creditors in a consistent and timely fashion. With this information (as well as the fact that, in this example, our companies’ tax rates are 40% of net income), we have everything needed to find out ROE and TIE for all six scenarios… Capital Structure 1: $400 million of shareholder equity Probability20%60%20% EBIT$40,000,000$85,000,000$130,000,000 Interest Expense$0$0$0

    Earnings Before Taxes$40,000,000$85,000,000$130,000,000 Taxes$16,000,000$34,000,000$52,000,000 Net Income$24,000,000$51,000,000$78,000,000 ROE6%12. 75%19. 5% TIEn. a. n. a. n. a. Expected ROE (overall)12. 75% ROE Std. Dev. (overall)4. 3% Capital Structure 2: $200 million of equity, $200 million of debt at 11% Probability20%60%20% EBIT$40,000,000$85,000,000$130,000,000 Interest Expense$22,000,000$22,000,000$22,000,000 Earnings Before Taxes$18,000,000$63,000,000$108,000,000 Taxes$7,200,000$25,200,000$43,200,000 Net Income$10,800,000$37,800,000$64,800,000 ROE5. 4%18. 9%32. 4%

    TIE1. 823. 865. 91 Expected ROE (overall)18. 9% ROE Std. Dev. (overall)8. 5% There are clearly trade-offs for both types of capital structure. We can observe that the 100% equity structure initially has a higher ROE, but fails to grow as fast as the ROE of the 50% debt structure as EBIT rises. This reflects the greater leverage that debt financing allows (as well as the fact that we’re getting less of our overall funding from equity in the second capital structure. However, with Capital Structure 2, we are obligated to pay creditors, which is why it records TIE results.

    It’s important to note that as EBIT rises, TIE also goes up, which means that with more money it’s easier to pay off our interest. The important of such become apparent when you realize that we spend over half of our EBIT on interest expense when EBIT is equal to $40,000,000. Of course, in Capital Structure 1, there are no debts or interest expenses to pay, which is a distinct advantage of having no debt to worry about. In addition to looking at the trends in each capital structure as EBIT increases, we can also look at each capital structure while aggregating the results.

    We can see that the expected ROE (calculated by taking the resulting ROE for each EBIT, multiplying by the chance that EBIT occurs in that particular capital structure, and adding our findings up) and ROE standard deviation are larger for the second capital structure, conveying that, at least in terms of ROE, the second capital structure is preferable to the first. Of course, along with EPS, TIE, and many other variables, one has to consider ROE in the context of the company’s situation as a whole…

    Capital structure would change as well as WACC if the company decides to recapitalize. • When debt level equals $210M, Total market value=Value of stock + Debt =210,000+256,138 =466,138 WACC=10. 94% ESP=$3. 44 •When debt level equals $280M, Total market value=Value of stock + Debt =280,000+179,782 =459,782 WACC=11. 94% ESP=$3. 85 When the debt level increases from $210M to $280M, the WACC will transfer from 10. 94% to 11. 94%. And EPS will increase from $3. 44 to $3. 85. As debt level increases, the value of WACC and EPS will increase as well.

    Let’s consider that Armstrong increased its total debt level from 140 million to 210 million by issuing new debt and using 140 million to refund the earlier issue at par and $70 million to repurchase stock. According to the spreadsheet, the stock price would be $23. 74. • MV of old debt = V – P*# of shares before recapitalization = 466,138 – $23. 74*13,693 = $141,030. 48 • Stock Price = (Value – MV of old debt) No. of shares before recapitalization = ($466,138 – $141,030. 48)/13,693 = $23. 4 It is higher than the company’s currently stock price $22 per share. The more debt a company has increases the volatility of its profits and risk as well. The shares of companies with higher debt are expected to have bigger returns than similar companies with less debt. Armstrong supposed to have higher returns. Then, let’s consider Armstrong issue an additional 70 million at 11% interest rate, without refunding the 140 million issue: Market value of equity = (EBIT – Interest Expense)(1- tax rate)/Cost of equity =(85000-11%*70,000-140000*10. %)*(1-40%)/14. 5% =$260772 Debt level=210000 VALUE = D + s = 260772+210000=470772 Stock Price=(470772-110000)/15000=24. 05 The debt levels are the same in both situations. Funding with debt is usually cheaper than equity because interest payments are deductible from a company’s taxable income. Therefore, the numbers of WACC are the same. In this case, we determine the better situation by calculating the total market value. With refunding, the stock price is $23. 32 and the market value is $466138. Without refunding, the stock price is $24. 5 and market value is $470772, which is higher than the market value of $466138. So we think without refunding the 140 million issues is a better alternative. The optimal capital structure for the Armstrong Production Company is one which offers a balance between the ideal debt-to-equity range and minimizes the firm’s cost of capital. It is the best debt-to-equity ratio for the Armstrong Production Company to maximize its value. However, it is rarely the company can reach optimal structure since a company’s risk generally increases as debt increases.

    In terms of theoretical numbers given to us Armstrong’s Chief Fiscal Officer, a debt level of $210 million (among the choices of no debt, $70 million, $140 million, $210 million, $280 million, and $350 million) offers the lowest Weighted Average Cost of Capital (WACC), which measures the cost of issuing new capital given the costs of equity and debt. WACC is measured as follows… WACC=(Debt/(Market value of equity+Debt)*Cost of debt*(1-Tax rate)+(Market value of equity/(Market value of equity+Debt)*Cost of equity

    Fortunately, we have all the numbers necessary to find WACC for different levels… DebtMkt. Val. EquityDebt costEquity costTax rateWACC $0$408,000T0%12. 5%40%12. 50% $70M$370,157T9. 5%12. 7%40%11. 59% $140M$314,311T10. 2%13. 5%40%11. 23% $210M$256,138T11. 0%14. 5%40%10. 94% $280M$179,78212. 7%16. 5%40%11. 09% $350M$100,42115. 2%19. 0%40%11. 32% We can clearly see that in this example, it is most advantageous to have $210 million of debt when considering costs alone. However, although WACC is important, it is not the only thing we must consider.

    Let’s assume that in the above example, EBIT is $85 million, and that we use debt to buy back stock. According to the information given to us by Armstrong, the EPS for various levels of debt are… Debt# of SharesEPS $020,537$2. 48 $70M16,817$2. 80 $140M13,693$3. 10 $210M10,788$3. 44 $280M7,710$3. 85 $350M4,425$4. 31 This demonstrates that, depending on a company’s objectives (being fiscally secure, being able to expand, or pleasing shareholders, for example) and its circumstances, a company may look for different things in a capital budget.

    Given this wide degree of ambiguity on the subject, what really matters, aside from the eventual capital structure being fiscally feasible, is that the decision-makers of a firm more or less agree upon the company’s goals, so that the company’s capital structure that is focused and consistent, and not attempting to please too many people or chase down contradictory goals. The upper management of Armstrong Production Company, a group which tends to either advocate fiscal conservatism or aggressiveness, will have to compromise to some degree to create a practical capital structure with clear objectives.

    The company should also consider the proportion of short and long-term debt when setting the firm target capital structure. Because expanding the company is implied to require more resources than Armstrong Productions has on hand, it seems likely that it will have to either issue more debt or stock in order to raise the funds needed to do so. Each carries their own risks, advantages, and disadvantages in doing so. Increasing the number of shares would raise money without increasing debt, but is likely to make shareholders unhappy because doing so dilutes EPS and thus decreases their total value to the shareholder.

    Unless top management is determined to expand without risking more debt and willing to take a loss, I do not see this option as a practical reality, partially because top management itself holds many of the company’s shares of stock. However, I cannot recommend taking on additional debt, or at least $200 million worth of new debt, as we suggested in our first hypothetical example. I say this because we must consider the worst-case scenario, the 20% chance that EBIT decreases to $40 million. The graph below illustrates the danger of such a possibility… The intersection here is (0. 648, 2. 1918), meaning that in the worst case scenario when debt still has an interest rate of 11%, Armstrong shouldn’t release more debt (unlike our recommendation for when EBIT stays at $85 million), as doing so will not only decrease EPS, but will jeopardize the company’s ability to pay its debts and obligations. Using a graphing calculator, we estimate that with the new capital structure, there is still a very small amount of EPS remaining at an interest rate of 11%, meaning that at this point the company remains in the black (specifically, EPS is roughly $0. 5). However, this surplus isn’t large at all, and the company would definitely be better off using the old capital structure in such a scenario. We also took a look at a company’s ROE and TIE, other important financial figures, when it has no debt and when it does have some debt. We found that debt can cause ROE to increase more rapidly as EBIT increases as well as remain at higher levels overall, which means that the company’s equity is being used more effectively than if it didn’t have any debt.

    At the same time, when a company incurs debt, it also creates a certain amount of risk that it will not be able to pay all of its interest in a timely manner (as measured by TIE), and that this risk increases as EBIT decreases. There are advantages and disadvantages to financing with and without debt, and the best possible mix of debt and equity depends on a company’s current financial state and its future goals or philosophies relating to expansion and growth. Obviously as the growth of the company, the company must need to increase its debt, consequently the company’s risk will increase as well.

    Therefore it must affect the company’s capital structure according to the capital structure ratio, which is long term debt/ (shareholders equity long term debt). Ultimately, the Armstrong Production Company can afford to issue additional debt, but it would be advised to do so conservatively, both to avoid the pitfalls of having too much interest accumulating (decreased credit rating, a devoured EBIT) and to guard against possible and unpredictable economic downturns in the future.

    Perhaps, if the company needs capital in the short term (say for an advantageous acquisition), it may be advised to consider issuing some debt while also issuing more equity, to not only reduce their respective weaknesses but also to take advantage of their best aspects. Armstrong Production Company A Study in Capital Structure

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