CASE 32 ‘The memo was unexpected and emotionally written, R. Craig Harrof is a beard member of the Fultex Corporation and a general manager with Titus Electronics, Harrof recently sent a memo to Elizabeth Bethea, the chief financial officer of Fultex. Harrot wrote that he "strongly believes that Fultex is highly overleverageci” and that “it is notin the best inter- ests of our stockholders to borrow in order to fund the $81 million expansion,” These concerns are based! on a comparison of the firm’s current, quick, debt/equity (D/T), times interest earned, and fixed charge coverage rati the industry average. (See Exhibit 3.) Harrof is especially concerned about the D/E ratio, whichis the ratio of long-term debt to cquity. The firm's D/Eis more than double the industry standard, a situation he finds “alarming,” And Harrof has taken great care to compile the industry standards, For comparison, he lectec! seven companies, affectionately called! the Magnificent Seven, which are roughly similar to Fultex in terms of sales and asset size. “The facts speak for themselves: We're much too dett-heavy at present, There's no point in con- sidering the use of debt to raise this $81 million.” FULTEX Fultex is a medium-sized producer of athletic uniforms, sportswear, sleepwear, and a variety of fabrics. Fultex has a well-deserved reputation for running a fully modernized operation with a commitment to maintaining state-of-the-art produc- tion facilities. And it has always paid considerable attention to cost management, For example, more than a decade ago Fultex became the first apparel company to install a fully integrated information system, which resulted in a faster, more accurate distribution of company data, This commitment to production and cost204 PART VI CAPITAL STRUCTURE management has paid off, Fultex is the envy of the industry, combining as it does low cost with procuct quality and service dependability. The firm is the dominant supplier of athletic uniforms to teams in nearly all sports and has well-developed distributing and marketing networkin this area, Management correctly estimated a few years ago, however, that the team uni- form cusiness was maturing, and it made the decision to expand into the retail market, The main strategy was to capitalize on Fultex’s reputation for quality and styling and to develop its own brands of leisure apparel such as sweatshirts and jogging suits. The company began promoting these brands on the retail level throughsporting goods dealers, many of whom were already selling Fultex’s ath- letic uniforms, The move into the retail business has been quite successful, and management has decided to increase sales to department stores and to design additional clothing lines to appeal to a wider range of the consumer market. A few weeks ago Fultex’s hoard of directors unanimously votes! to approve the acquisition of $81 million of external funds that will be used to expand man- ufacturing facilities and to develop a new R + D plant, The R + D factory is another of Fultex’s steps to improve efficiency and will enalle the firm to test production systems, Top management considers this project absolutely cssen- fial for Fultex ta succeed in increasing its market share, thoughitis net expocted to improve the firm’s profitability in the near future, REACTION TO HARROF’S MEMO The financing of the needed $81 million has generated some controversy, and Bethea is discussing Harrof’s memo with William Gibbs, a vice president, Bethea concedes that Harrof has raised some interesting points, She is far from convinced, however, that the company is cebt heavy. Harrof’s figures are indis- putable but, she believes, they ignore the capacity of the firm to incur debt. “First,” she remarks to Gibbs,"I suspect we're more profitable than the typical firm. Talso suspect cur business risk is low compared to these companies. For example, we're well diversified in terms of markets and product line for a firm our size, An important issue is the overall risk that our stockholders are expesedl to, which is determined by our business risk as well as our financial risk, Harro is looking at only one side of the issue. And don’t forget the cus- tomer loyalty we've worked so hard to develop. This makes us less vulnerable than our competitors to economic downturns.” THE VIEWS OF THE LARGEST STOCKHOLDER Bethea then shareci with Gibbs the details of a recent meeting with Anthony Barro, Barro, a billionaire, is Fultex’s major stockholder and owns 4 million shares (26 percent of the firm’s stock}. He is eager to maintain effective control of the company, which he believes can be accomplished with at least 30 percentCASE 22 FULTEX 203 of the shares, Barro understands that Fultex neccis external funds and told Bethea that, cue to ather business ventures, his financial situation was such that he could only commit up to $25 million of equity any time during the next three years. In addition, Barro believes that the market does not fully appreciate Fultex’s future prospects and cites the 1995 drop in the price-earnings (P-E) ratio as evidence, He acknowleciges, however, that Fultex’s current P-E ratio is relatively high by historical standards, (See Exhibit 2,) In addition, Barto feels that the Federal Reserve will do “almost anything” to avoid a recession. In his view there isa real danger that inflation will escalate sharply. This would cause an increase in inflationary expectations that, in turn, would cause interest rates to rise. In short, he feels that interest rates are currently very attractive. All things considered, Barro would prefer that Fultex issue debt to raise the needed funds. However—and he leaves this up to Bethea to cletermine—if the bond option scems tao risky or if there are other mitigating factors, Barro would sup- port the stack option, Bethea was a Lit surprised at Barro’s interpretation of the Federal Reserve's priorities, Fultex is a client of Wharton Econometrics, a well-respecte! macro economic forecasting firm, and Bethea faithfully reads such prominent financial publications as the Wall Street Journal and the Econemist. Most economists feel that the Fed is very much concerned with containing inflation, even at the risk of precipitating a recession, and some even feel that an econemic downturn is quite likely in the next 12 to 24 months, She has noticed, however, that no ¢ nomic forecaster believes that any recession will be as severe as the ones in 1974 to 1975 and 1982, Bethea realizes, though, that economic forecasting is an inex- act science and majority opinions can easily be wrong. THE FINANCING OPTIONS There are three financing possibilities Fultex $81 million. considering to raise the needext Stock Option, This involves the sale of new common stock at $32 per share, The firm would net $30 after the $2 per share flotation cost. Fond Option, The bonds would be 15-year debentures bearing an interest rate f 10 percent. The bonds would be callable after cight years at a price $1,100 per $1,000 band, declining to $1,000 by year 15, The indenture will not allow Fultex to issue any new debt with a higher priority, and Fultex is restricted from paying dividends in excess of 70 percent of net income, The debentures carry a modest sinking fund provision, Beginning at the end of year 5,5 percent of the bonds would need tobe retired each year: (Note: Fultex Would have a balloon payment equal to 50 percent af the issue at the end of year 15,) Combinstioi Option, This is a 50-50 mix of the stock and bond options previ- ously described,206 PART VI CAPITAL STRUCTURE Betheaand Gibbs then discuss future financing needs beyond those considered in Exhibit 8, Gibbs makes the point that industry production techniques are “ever changing” and that itis crucial that Fultex stay alert for the possibilities of innova- tion and efficiency if itis to flourish and not merely survive. It is quite difficult, however, to estimate the funds that would be required if Fultex suddenly had to alter its method of production. “best guesstimate” is that S10 to $20 million would be necessary. Though Bethea would like to be able to finance this inter- nally—and she believes that Fultex has roughly $5 million of excess liquidity at resent—conversations with the firm's investment bankers indicate that this money could be raised externally, even if Fultex borrows the entire $81 million. Bethea instructs Gibbs to make a detailect analysis of the three options and report back to her. “I, of course,” Bethea emphasized, “will make the recommen- dation to the board. This is likely to be a sensitive matter given Harrot’s memo and Barro's preferences, Your job is to be your usual thorough self, My job is to scrutinize the information you compile and make that recommendation.” QUESTIONS 1, (a) Calculate the following break-even sales volumes for Fultex atthe p ent time (1995) assuming CGS is the only variable « i, EBT =0, Use FC. ~ T=Vvojs ii, Cash flow from operations; that is NI + Dep. = 0. Use (©) Expr ages are69.8 and 59.4 for the seven competitor (c) What do your answers suggest about Fultex’s risk? 2, Calculate Fulter’s 1995 debt service coverage and capital service coverage and 1.9 respectively for the firm's seven competito EBIT + Leas EC = 3S DSC = Tease DDO) Where DD = debt due EBIT + Lease CSC = TF Tease + (DD + Diva (a=)CASE 32 FULTEX 207 3. (a) Calculate Fultex’s 1995 DOL, The competito DOL = 1 + FOC/EBIT. (b) Caleulate its DFL (clegree of financial leverage), The competitors’ aver- age is 1.1. Use DFL = 1 + INT/TBT. (¢) Caleulate its DTL (cegree of total leverage). The competitors’ average is 3.3, Use either DIL ='1 + FC/EBT or DIL = DOL x DFL. (d) Interpret your answers. (e) What do these figuu overall risk? In light of your previous answers, the information in Exhibit 3, and other information in the case, evaluate Harrof’s argument that Fultex is overlev- ered at the present time (1995), ! average is 3.0, Use suggest abcut Fultex’s operating, financial, and s Complete the table in Exhibit 7. (Assume a dividend of $.10 per share on any new stock) (a) What is Fultex’s 1996 and 1997 estimated earnings per share (EPS) ifituses the bond option? The stock option? The 19% and 1997 estimated EPS are $2.33 and $3.22, respectively, if it uses the combination option, (b) What is the 1996 sales indifference point between the bond and stock options? Continue to assume that CGS is the only variable cost. 2 Complete the tables below showing selected financial ratios for Fultexin 1996 and 1997 for each financing option, assuming no external financing beyond the $81 million. These estimates are based in part on the best-guess (most likely) sales forecasts of Exhibit 8, Lease payments are $3,360((00) each year. See Exhibit 5 for yearly dividends and debt due without any new financing, 1596 Estimates Pond Stock Combination % 46 1997 Esimares “fe aK Naw Jeb service coverage (ee questicn 2), «capital service coverage (soe question 2). FCC = iyo charge coverage (EDIT + Lease)/literest + Lease)2 PART VI CAPITAL STRUCTURE 8, With the stock option, the 1995 market value of Fultex is predicted to be $537.1 million, ignoring current liabilities, This estimate assumes the $95.5 million book Value of long-term debt equals market value and the price per share is $22. Miller and Medigliani’s equation, V; = Vy + (I< D), implies that the value of the firm will change by { times the change in interest-bearing debt, where f is the corporate tax rate, (a) Ascuming the tond option is chosen and using MM’s equation, the value of Fultex’s equity is predicted to be $393 million, with a price per share of $35.11, Show how these estimates were obtained. NOTE: Using the combination option and assuming 1.35 million new shares are issued, the price per share is predicted to be $33.52 (6) Anestimate of value using MM’ equation is usually considered to be an upper limit to the value of a levered firm in an efficient market. Why? 1. Use the workshect in Exhitit 6 to develop a worst-case cash flow forecast. Note that the figures are in millions and the impact of the new financing is ignored. 10, Play the role of a consultant, Based on your previous answers, information in the case, and any other calculations you think are relevant, what option do you recommend? Defend your position, SOFTWARE QUESTION 11. A few yearsago, Fultex altered its production techniques in such a way that variable costs increased and fixe! operating costs decreased. Management estimates that if the changes had not been made, 1995 variable cests would be 6b percent of salesand fixed cash operating costs (“operating expenses”) would be $120 million, (a) Assume the production changes had never been made, Redo questions Ub), 2, 3{a), 3(6), and 3( (b) What would Fultey’s 1995 EBIT have been? (6) Do your answers to part (a) affect your answer to question 4? Explain,CASE 32 FULTEX 209 12, (a) Anumber of Fultex’s top executives compiled the following worst-case scenario, Sales Operat NWC/sales zB 2 zB 2 pps 10 10 10 10 Capital spent [Nato DPS is dividend per chare, NWC isnot working copia Develop a cash flow forecast assuming the entire $81 million is borrowed. What are the implications of this forecast for the financing cccision? (b) When Elizabeth Bethea, the firm's CFO, was shown the above forecast, she thought the operating margin assumption was “too high” and NWC/sales was a “bit optimistic.” Redo the forecastassuming (1) a 12 percentoperating margin in 19% and 1997, 13 percent operating margin in 19%8 and 1999, and (2) NWC sales is 24 each year. () Assuming the same operating margin each year, how low can operating margin go before the cumulative cash flow in 1999 becomes zero? Use all the other assumptions in part (a). What is the implication of your answer for the financing cheice? (You may want to consult Exhibit 2.)PART VI CAPITAL STRUCTURE EXHIBIT 1 Fultex’s Current (1995) Income Statement and Balance Sheet Operating expenses Depreciat EDIT Interest Enmings before tayes Taxes (400) Netineome E pershare ids per share 1995 Polanc h ounts receivable Invent Current a Net fixed Total assets ‘ae Seater (5 Millions rece (S Mbilicns Libis and Eg Accounts payable Debt due ber cureont Current iat Bonds Equity Teta bil jes anc equity EXHIBIT 2 story of Sales, PE, and Operating Margin 2a 3 31 125 55 12 3 129 3 48 7 46 Lat 67 M2 89. 22 us 150 a7 las 2 LL (continued)CASE 32 FULTEX 211 EXHIBIT 2 (Continued) Year Sas imiliens} 9 luo 2 140 BS Md ating marin equals (FRIT + Dep.y/Sals EXHIBIT 3 Selected Financial Ratios, 1995 (Present Year) Tndusery Average Current Quick 1S Debt 6 DE 024 Times interest carne ve Kc 3 (DJs ato of langecrm det to uty TCC = fixed charge coverage = (EEIT ~ Losey/dakerest + Lo Noematizel Inceme Statement 5 Trdsery Operating expenses ud Depreciation ud EBIT m2 Interest 9 Enenings before tes 53 Taxes (40) 32 Nal212 PART VI CAPITAL STRUCTURE EXHIBIT 4 Fultex’s Pro Forma 1996 and 1997 Income Statements ($ Millions) Gross margin (Operating expenses Deprecialio FeIT Interest Eammings before taxes Taxes (47) 24 Net income P35 Nowe: T Opera forcast assumes that Fullex maintains its 1995 eperating margin of 14.6 percent. Dep}/Sales. The impact of the new financing is not considers EXHIBIT 5 Fultex’s Best Guess (Most Likely) Sales and Cash Flow Forecast: 1996-1999 (¥ Millions) 1996 S640 270 Cash flow from operat «Os =Dividenats ft Debt dc g = Change in wrking capital 76 =Capital spending Cash flow Sd [Note: These estimates assume that the change in net worki change in sales. The figures cle not, howvever, consider the impact cf the new financing S81 million. At the present time (1995) the fim has roughly $5 million of excessCASE 32 FULTEX 1 EXHIBIT 6 Worksheet for a Worst-Case Cash Flow Forecast: 1996-1999 ($ Millions) Sales Operating profit Depreciation mw us mao MS FBIT Interost 22 ss so rT Taxes (40°) — — — — Depreciation mw us mao MS (Cash flew freen operations 7 1 La ua = Capital spe a poe 28 Cash fe No: Let the 1996 change in working capital equal 5 om 19 Fer ines the change in sales let this change equal 22 times the yearly change in ales, ®AL present (1998) the firm ns aprecsimately $5 milion of exes Hquity. This Foocaat does no csi the impact ofthe new financing cf $51 million EXHIBIT 7 Yearly Cash Outlays (Before Taxes) of Each Financing Option’: 1996-1997 ($ Millions) Tanl Opin Seek Option Taman Th Dis in. [Diu Tn tho ditional interest ana Di. dh exe lividans, There ake no actin Sinking fun paymens du ing. 1985 lo 1997 with any cf the inancins options.214 PART VI CAPITAL STRUCTURE EXHIBIT 8 U.S, Recessions Since 1945 Resesn Pak 69 Tiegh Reesien Procaiing Expansion (Mend OM niiys Feb, 1945-Oct. 19 s Now, 1948-Qct, 1949 1 July 1953-May 19 lc Aug, 1957-—Apr s Apt. 1960-Feb 961 le Doe, 1969-Now. 1970 1 Now, 1973-Ma. Ie Jan, 19S) July 1 6 July 1981-Dee. Is July 1950-Mar. 1 7 7 National Rureaus of Feononnic Research Note: The National Bureau of Eecnomiic Research (NBER) i of a recession (ven the ecentomry peaks) anit its endl (when the economy this is trough and begins to recovers The last US. recession (as of 1995) erste March 1991,