Case 10-1 - Solution

Estimated time to complete this case is one hour.

  1. The calculations are:

Amounts in $millions

/ 1997 / 1998 / 1999 / 2000
Total debt / $ 357.6 / $367.5 / $ 503.1 / $ 30.9
Net debt / 59.5 / 259.1 / 276.7 / (23.7)
Total debt at market / 357.6 / 205.3 / 304.4 / 23.8
Net debt at market / 59.5 / 96.9 / 78.0 / (30.8)
Equity plus minority interest / 618.8 / 275.9 / 126.1 / 290.5
Equity (MV) plus MI / 1,363.5 / 380.8 / 219.1 / 1,316.4
Ratios
(i) Total debt to equity / 58% / 133% / 399% / 11%
(ii) Net debt to equity / 10% / 94% / 219% / (8)%
(iii) Total debt to equity (MV) / 26% / 54% / 139% / 2%
(iv) Net debt to equity (MV) / 4% / 25% / 36% / (2)%

Calculations for 2000:

(i) $ 30.9/ $ 290.5

(ii) $(23.7)/$ 290.5

(iii) $ 23.8/ $1,316.4

(iv) $(30.8)/$1,316.4

  1. All of the ratios show rising financial leverage through 1999 with a significant decline in 2000. However the levels are quite different. When the market value of equity is used in the denominator, the 1997 leverage ratio seems quite reasonable, especially when net debt is used in the numerator. However the gross debt-to-equity ratio for 1998 is high and rises to an alarming level in 1999, even using the market value of equity. This comparison highlights one problem with using market values in the debt-equity ratio: changes in market price may result in significant changes in the ratio over time.
  1. There is no simple answer to that question. Normally, the last ratio (net debt at market and equity at market) is most informative. However, using that ratio makes several implicit assumptions.

First, it assumes that all cash equivalents and short-term investments can be used to repay debt. If the cash equivalents are not available for that purpose (for example, because they are in a subsidiary and cannot be used without regulatory permission or tax payments) then gross debt should be used. In the case of Read-Rite it appears that large cash equivalents (in excess of operating requirements) were maintained for liquidity purposes (to reassure customers and suppliers) rather than because of any restrictions.

The second implicit assumption is that declines in the market value of debt can be realized. When a company is financially troubled, creditors may be willing to forgive a portion of the debt or restructure the debt (reducing the interest rate, for example). Subordinated creditors (such as bondholders) are more likely to do so because of their weaker security position. Banks and other senior lenders rarely make such concessions unless the firm is close to bankruptcy.

The answer, therefore, requires an analysis of the company and the purpose of the calculation (i.e. for which creditor). Our point is that, while ratio (iv) appears to be the best measure of Read-Rite’s debt burden, it should not be used without additional analysis, leading to an understanding of operating and other liquidity needs.

  1. The required calculations are:

Amounts in $millions

/ 1997 / 1998 / 1999
Gross margin / $ 238.8 / $(132.8) / $ (23.2)
Gross margin % / 21% / -16% / -3%
Operating income / $ 119.7 / $(352.9) / $(182.2)
Interest coverage ratio / 7.6X / (11.9)X / (5.7)X
Free cash flow / $ (82.7) / $(195.0) / $ (24.8)

Gross margin % = gross margin/sales [1997 = $238.8/$$1162.0]

Operating income = sales – (cost of sales + operating expenses) [1997 = $1162.0 – ($923.2 + $119.1)]

Interest coverage ratio = operating income/interest expense [1997 = $119.7/$15.7]

Free cash flow = cash from operations – capital expenditures [1997 = $190.1 - $272.8]

All three statistics reflect Read-Rite’s poor operating results. Gross margin for 1998 and 1999 was negative; revenues did not even cover the costs of production. The interest coverage ratio was negative for 1998 and 1999, reflecting negative operating income. Free cash flow (cash from operations less capital expenditures) was negative for all three years. Cash from operations was negative for 1998 (see exhibit 10C-1).

The company’s sales were declining and its debt burden (by any measure) rising. Thus it is not surprising that the auditor gave a going concern qualification at September 30, 1999.

  1. There were at least six benefits (to Read-Rite) from the exchange offer:
  2. The face amount of the convertible debt was reduced by 50% from $1,000 per old bond to $500 per old bond.
  3. The interest burden of the convertible debt was reduced from $65 per old bond (6.5% coupon rate) to $50 per old bond (10% coupon on $500 face amount).
  4. Read-Rite was permitted to pay interest on the new bonds in common shares, increasing cash flow. [In fact the company did pay interest in common shares until the new bonds were converted.]
  5. As part of the exchange offer, Read-Rite was able to raise $61 million from the sale of additional new notes.
  6. Read-Rite was relieved from complying with any of the debt covenants of the old bonds.
  7. The lower conversion price of the new bonds increased the likelihood that they would be converted into common shares, eliminating that portion of the company’s debt burden and improving its financial condition.

The last “benefit” for Read-Rite is also the cost borne by the stockholders. As can be seen from the 2000 data in Exhibit 10C-1, the conversion of the bonds into common shares (and the additional shares issued as interest payment on the new bonds) more than doubled the number of common shares outstanding, diluting the interest of the existing Read-Rite common shareholders. Any future earnings would be spread over more shares, reducing earnings per share.

The conversion effect of the new bonds exchanged and sold can be calculated as ($162.6 + $61.2)/$4.51 = 49.6 million shares ($4.51 is the conversion price).

  1. The gain can be estimated as follows:

Face amount of old bonds exchanged $ 325.2 million

Face amount of new bonds (162.6)

Gross gain on exchange $162.6 million

Write-off of unamortized issue cost (5.0)

Net gain on exchange $157.6 million

There is an unexplained $1 million difference between this amount and the $158.6 million recognized.

  1. The $158.6 million gain really originated in prior years (mostly 1998 as shown in exhibit 10C-1), when the market value of the convertible bonds declined. Its recognition in the year of realization (2000), while required by GAAP because it was realized in that year by the exchange offer) is arbitrary.

There is also some question as to whether there was any economic gain, as well as the amount of the gain at the time of the exchange. At that time, Read-Rite exchanged new bonds with a market value no lower than that of the old bonds (otherwise bondholders would not have been willing to make the exchange). In addition, while the face amount of the new bonds was one-half the face amount of the old bonds, the conversion option was much more valuable.

As discussed in the chapter (page 337, including footnote 26) a convertible bond should be viewed as a full coupon bond issued at a discount plus a warrant. The market value of the warrant portion of the old bonds was virtually zero while the warrant portion of the new bonds had substantial value due to the conversion price that was only 15% above market. If the bonds were accounted for using this component approach, the gain would be much lower than the gain computed simply by comparing the face amounts.

  1. The advantages of the new notes were
  2. Read-Rite was able to survive
  3. The lower conversion price increased the possible gain on the bonds.

The disadvantages were:

  1. The lower face amount of the new bonds reduced the (face) amount that would be received at maturity.
  2. The bondholder would receive lower coupon interest (see answer 5b).
  3. The bondholder might receive Read-Rite shares instead of cash interest.

Presumably bondholders believed that the two advantages outweighed the disadvantages and that the exchange offer was more likely to result in recovery of their in investment.

That decision was vindicated by subsequent events. At the fiscal 2000 year-end stock price of $11.25, the new bonds had a conversion value of $2,494.50 per bond ($11.25 x $1,000/$4.51) or $1,247.20 ($2,494.50/2) per old bond. Despite the lower face value, the subsequent rise of the common share price enabled them to more than recover the (old) face value.

10C-1