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Fredrik Regner

on 24 March 2011

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Transcript of Tonka

Tonka Risks Leveraging Up Capital Structures Recommendations 5th largest toy company in the US
Exceptional profitability in 1985 & 1986
Conservative management
Utilize financial resources effectively
Meeting business objectives
1. Diverisify product line
2. Expand internationally Financial Risk Business Risk Part of Total Corporate Risks
Risks associated with company’s operations
-Uncertainty about demand
-Uncertainty about output prices
-Uncertainty about costs
-Operating leverage: use of fixed costs rather than variable costs.
Tonka: Seasonal demand, short product life cycle, hit-or-miss nature, inventory Levered Cost of Equity
RF = 7.08% (10-Yr Treasuries Bond)
βE = 1.1 (given)
RM (S&P 87’Jan & 86’Jan stock prices)=246.45 – 208.19/208.19 = 18.4%

RE = RF +  βE (RM – RF )
= 7.08+1.1(18.4 -  7.08)  
=  19.532%
Unlevered Cost of Equity
RE  =  R0  +  D/E  (1 – TC)(R0 – RD)  

0.19532 = R0 + (16.7/155.5)(1 –  0.45)(R0 –  0.075)
R0 =  18.86%
Hamada Equation to find Unlevered Beta
βE =  β0[1 + D/E(1 – TC)]

1.1= β0 [1 + 16.7/155.5 (1 – 0.45)]
β0 =1.039
Additional   risk   concentrated   on   common   stockholders   as   a   result   of   financial   leverage,  ie. use  of  debts  or  preferred  stock
βE = β0 + (D/E)(1 – TC)(β0– βD)

Assuming riskless debts, βD = 0, thus
βE = β0[1 + (D/E)(1–TC)] Financial risk for different D/E-ratios Times Interest Earned (TIE) = EBIT/Interest Exp Current Ratio = Current Assets/Current Liabilities Value Added Assuming MM world with taxes,
VL = EBIT(1 – TC)/R0 + D*TC
Du Pont Sensitivity Analysis Pessimistic (-20% in gross profit)
Optimistic (+20% in gross profit) Changes in Earnings Per Share Changes on Return on Equity Market Reactions
Other factors:
‘Signaling effect’:
Issuing   debt   will   give   a   signal   to   the   market   that   the   company   is   doing   well   and   is   expecting  to  have  good  results Imperfect knowledge:
Usually   managers   have   more   information   and   they   tend   to   buy   back   shares   when   they  think  that  they  are  underpriced Degree of risk aversion:
More   risk   averse shareholders   may want   to   sell   their   share   if   the   leverage   becomes   too   big.  Decreasing the amount of outstanding shares. Optimal An optimal capital structure that maximizes shareholders’ value
-maximizing the value of the firm
-minimizing the WACC WACC = D/D+E * RB * (1 – Tc) + E/D+E * RE
RE = R0 + D/E (1 – Tc) (R0 – RD)
TC  =  45%   RE  =  19.532%   R0  =  18.86%
RD =   Weighted average of old   interest   rate   (7.5%)   &   interest   expense   on   new   debts   (9.5%) An Aggressive Policy Increase the amount of debt in the firm’s capital structure
Currently, have low D/E ratio, small increases in financial distress costs
-Equity-debt swap
-Repurchasing stocks
-Outsourcing Refinancing
Equity-Debt swap
When all or a portion of the shareholders are offered to convert their shares to bonds
Stock price to rise and increases the D/E ratio
Tender Offer: where company offers the shareholders extra value if they choose to convert their shares Repurchasing stocks
Signaling effect
Debt tax-shield
Convertible bonds
Reduce the conflict of using too much debt,
Reduce possibility of inability to repay interest payment, which decreases the risk of bankruptcy Expanding
Obj 1: No single toy to account for >25% of sales
Obj 2: Expand sales base internationally
Money is reinvested in expansion rather that handed out as dividend, thus will have a magnification result
Sell assets to reinvest in the main function of the company
Help focus on what the company is really good at and help cut costs
Caveat: reliance on the outsourcing firm’s performance
What should they do? What really happened? Reasonable business risks, β0 =1.039 Take up 40% of debt to:
Finance profitable projects
Reduce risks of takeover
Carry out LBO
Tonkas was purchased by Hasbro in 1991 Case I: No corporate taxes, no bankruptcy costs
Case II: Corporate taxes, no bankruptcy costs
Case III: Corporate taxes, bankruptcy costs
Trade-Off Theory 
Assumption of fixed interest rate of 9.5% on new debt
Interest rates vary with increased debt load
Resultant WACC not accurate reflection
Optimal: 40% of debt
Interpretation Q&A
Full transcript