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Video Now is considering two options to address financial issues: 1) acquiring its internet competitor Kramer.com or 2) issuing new shares of equity. It has compiled financial data on both companies and the industry to evaluate the options. It must determine the best acquisition price for Kramer.com and the appropriate amount of equity to issue to achieve its financial targets.
Video Now is considering two options to address financial issues: 1) acquiring its internet competitor Kramer.com or 2) issuing new shares of equity. It has compiled financial data on both companies and the industry to evaluate the options. It must determine the best acquisition price for Kramer.com and the appropriate amount of equity to issue to achieve its financial targets.
Video Now is considering two options to address financial issues: 1) acquiring its internet competitor Kramer.com or 2) issuing new shares of equity. It has compiled financial data on both companies and the industry to evaluate the options. It must determine the best acquisition price for Kramer.com and the appropriate amount of equity to issue to achieve its financial targets.
1. Write or print your name ONLY on the back of the last page of the exam booklet.
2. Please write on one side only of pages in exam booklet.
3. You may leave the room at any time, for a break, but you are not to discuss the exam with anyone.
4. You are allowed to have one 8.5 x 11 inch pages of notes written on the front and back.
5. Please provide an audit trail for your answers.
6. Partial credit will be granted where appropriate.
7. Good luck!
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Video Now, Inc.
Video Now, Inc is a rapidly growing retail chain of video rental stores in the metropolitan New York City area. Founded in 1991 by native New Yorker, Stuart Pidasso, Video Now had expanded from a single store in lower Manhattan to a chain of 150 stores spanning the five boroughs of New York. By providing a more extensive list of foreign and independent films and by maintaining a reputation for superior customer service, Video Now was able to compete directly with the industry leaders. Unlike national chains like Blockbuster Video, however, Video Now had no desire to expand the business beyond the metropolitan New York area.
As Pidasso and other members of the board of directors conducted their annual review of the business in J anuary of 2002, they were concerned with three issues. First, Video Nows recent growth had dramatically altered its capital structure. While Video Now had once been a debt-free, cash-rich company, it now carried enough debt that the companys debt rating had fallen from AAA to AA. Although the board viewed the costs of financial distress as negligible at the current debt level (due to the ease of liquidation of inventory and real estate), Pidasso and the other board members had a strong preference for maintaining a AAA debt rating. Second, the companys recent growth had reduced the companys cash balance well below its target level of $10 million. Third, the recent entry of internet-based competitors into the home video market had eroded some of Video Nows revenue. These internet-based competitors offered home delivery of videos by allowing customers to choose from available movies on a webpage, then specify a time for delivery.
Restructuring Alternatives
To address these issues, the board was considering two independent, but not mutually exclusive alternatives. Under the first alternative, Video Now would acquire the equity of Kramer.com, one of VideoNows main internet-based competitors. Under the second alternative, Video Now would issue new shares to the public and use the proceeds to alter its financial structure. Currently, VideoNows shares are priced at $26 per share in the market.
Over the past two months, Pidasso had carefully amassed a large amount of data that he considered relevant to the restructuring alternatives. These data include VideoNows current balance sheet (Exhibit 1), its income statement for the most recent fiscal year (Exhibit 2), data on current yields on debt securities (Exhibit 3), historical rates of return on various financial instruments (Exhibit 4), and financial data for other local video chains and internet-based competitors (Exhibit 5). His plan was to conduct a thorough analysis of each alternative independently. That is, each alternative would be evaluated as if the other alternative was not being pursued.
Acquisition of Kramer.com
Of the two internet-based competitors operating in the New York City area, Pidasso felt that Kramer.com was a superior acquisition candidate since, like VideoNow, it focused its strategy on customer service. To date, this strategy had been quite effective, as evidenced by Kramer.coms large share of the internet-based market.
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By acquiring Kramer.com, VideoNow would gain entry into the growing market for home video delivery. Internet-based competitors such as Kramer.com had already substantially eroded the sales of local video chains. Exhibits 6 and 7 contain balance sheet and income statement data for Kramer.com. Based on Pidassos projections, Kramer.coms sales could be expected to grow at an annual rate of 15% for the next two years (2002-2003), then at 10% for the following two years (2004-2005). Beyond that point, Pidasso expected the companys cash flows (not sales) to grow at a constant rate of 4% per year for the forseeable future.
In addition, Pidasso envisioned several other benefits to the acquisition. First, by combining corporate headquarters, several administrative positions within Kramer.com could be eliminated. Pidasso estimated that these staff cuts would permanently reduce Kramers selling and administrative expenses as a percent of sales by 4%. Second, by combining the inventory of VideoNow and Kramer.com, Pidasso estimated that Kramer.coms net working capital could be reduced to 20% of its sales and remain at that percentage of sales in the future. Third, Pidasso expected to alter Kramer.coms financial structure so that only 10% of the companys total capital would come from debt sources. By Pidassos estimates, this would raise Kramers debt rating from its current level of A to AAA, thereby reducing Kramers borrowing costs. (Of course, any debt issued by VideoNow to finance the acquisition would be rated AA as per their current bond rating.) Pidasso expects that Kramer.coms cost of goods sold as a percent of sales will remain constant even if the company is acquired.
Exhibit 8 contains projections of capital expenditures and depreciation for Kramer.com over the next four years. If VideoNow pursues the acquisition of Kramer.com, Pidasso expects that the transaction will be structured so that VideoNow purchases the equity of Kramer.com and assumes responsibility for the companys outstanding debt.
The Equity Issue
Pidasso believes that in order to achieve a AAA debt rating, VideoNow must reduce its debt level. In order to determine the appropriate debt level, he has collected data on the debt structure of other retail video outlets. These data are given in Exhibit 5. In addition, Pidasso believes that it is essential for the company to maintain a minimum cash balance of $10 million.
In order to reduce debt and increase the companys cash balance, Pidasso is considering a public issue of shares. The proceeds of the stock issue would be used to repurchase some of VideoNows existing long-term debt and to increase the companys cash balance to the the target level. Pidasso plans to assume that the debt level following the equity issue will remain constant for the forseeable future.
After assessing how much equity to issue, Pidasso intends to evaluate the effects of the stock issue and corresponding recapitalization on the market value of VideoNow and on its share price. In making this assessment, Pidasso plans to assume that the companys current market value is based on the assumption that the current debt level will remain constant into the future.
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Questions
1. (50 points) Should VideoNow pursue the acquisition of Kramer.com. If so, what price per share should they offer? In answering this question, assume that the proposed equity issue does not take place.
2. (50 points) How much equity should VideoNow issue in order to achieve a debt rating of AAA and a cash balance of $10 million? At what price should the equity issue take place? How many shares will be issued? What will be the market value of VideoNows common stock following the equity issue? What will be VideoNows stock price following the equity issue? Should VideoNow pursue this recapitalization?
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Exhibit 1
VideoNow, Inc. Income Statements (in $ thousands)
2001
Sales 96142 Cost of Goods Sold (76,914) Selling and Administrative Expense (4,807) Operating Income 14,421 Depreciation (6,428) Earnings before Interest and Taxes 7,993 Interest Expense (3,322) Net Income before Taxes 4,672 Taxes (1,869) Net Income 2,803
Shares outstanding 1200 Earnings per share 2.34
The companys marginal tax rate is 40%.
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Exhibit 2
VideoNow, Inc. Balance Sheet as of December 31, 2001 (in $ thousands)
Assets Liabilities and Owners Equity
Cash $ 3,114 Accounts Payable $ 14,173 Accounts Receivable 35,610 Inventory 60,528 Current Assets 99,252 Current Liabilities 14,173
Gross Property, Plant & Long-term debt 51,500 Equipment 86,040 Common Stock ($1.00 par) 1,200 Accumulated Depreciation (12,856) Paid in Surplus 2,400 Net Property, Plant & Retained Earnings 103,163 Equipment 73,184 Total Liabilities Total Assets $ 172,436 & Owners Equity $ 172,436
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Exhibit 3
Current Financial Market Data
Yield-to-Maturity Type of Bond Maturity as of J anuary 2002
Book Book Value of Coupon Value Shares Long-term Interest Sales of EBIT Outstanding Stock Debt Rate Bond (in thousands) Assets (in thousands) (in thousands) Price (in thousands) on Debt Rating Beta Retail Chains
Kramer.com 41,850 34,875 5,965 1,250 23.25 9,688 6.98% A 1.80
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Exhibit 6
Kramer.com Income Statement (in $ thousands)
2001
Sales 41,850 Cost of Goods Sold (31,388) Selling and Administrative Expense (3,348) Operating Income 7,115 Depreciation (1,150) Earnings before Interest and Taxes 5,965 Interest Expense (676) Net Income before Taxes 5,288 Taxes (2,115) Net Income 3,173
Earnings per share 2.54
The companys marginal tax rate is 40%.
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Exhibit 7
Kramer.com Balance Sheet as of December 31, 2001 (in $ thousands)
Assets Liabilities and Owners Equity
Cash $ 2,378 Accounts Payable $ 7,087 Accounts Receivable 7,122 Inventory 12,106 Current Assets 21,606 Current Liabilities 7,087
Gross Property, Plant & Long-term debt 9,688 Equipment 17,208 Common Stock ($1.00 par) 1,250 Accumulated Depreciation (3,939) Paid in Surplus 2,500 Net Property, Plant & Retained Earnings 14,351 Equipment 13,269 Total Liabilities Total Assets $ 34,875 & Owners Equity $ 34,875
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Exhibit 8
Kramer.com Projected Capital Expenditures and Depreciation, 2002-2005 (in $ thousands)
Should VideoNow pursue the acquisition of Kramer.com. If so, what price per share should they offer? In answering this question, assume that the proposed equity issue does not take place.
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Question #2 (50 points)
How much equity should VideoNow issue in order to achieve a debt rating of AAA and a cash balance of $10 million? At what price should the equity issue take place? How many shares will be issued? What will be the market value of VideoNows common stock following the equity issue? What will be VideoNows stock price following the equity issue? Should VideoNow pursue this recapitalization?