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Dougall & Gilligan Global Agency
Dougall & Gilligan GlobalAgency (D & G), one of the larger advertising agencies in theworld with over 11,000 employees, had its origin in 11! through a predecessor firm" #ts
head$uarter is in the %ew or' city of ""A" *oreign business of D & G now accountsfor + - of the total commission and fee income" .esides, the ten largest clients provides!/ - of the income" D & G is the corporate umbrella under which five operating units arethere, D & G being the largest"
1) What are the company’s financial condition and performance, its funds
requirements, and business risk?
Sources and Applications of Funds (11!1")
aor uses of funds increases in intangible assets (23/"+ ) and net fi4ed assets (2!3"5)" 6his is consistent with the ac$uisition strategy pursued by the company over the pastyears" Another significant uses of funds are dividends (27 ), currency losses (2+0 ust in 1!), stoc' repurchases and other adustments that could reduce shareholderse$uity" oreover, cash position has improved over this period (25/ )" 6hese uses werefinanced largely by the company8s profitable operations (2!70 ), the issuance ofconvertible subordinated debentures (231 ) and stoc' issuance (2+ )" 9ther minorsources of funds are increases in ban' loans (2!5 ), accruals and deferredcompensations" (refer 6able 1)
#able 1$ Source and %ses of Funds (11!1")
1
Sources %ses
%et #ncome !1" #ncrease in :ash 5/"/
#ncrease in .an' %otes !5"0 #ncrease in Accounts ;eceivables 1!"0
#ncrease in Accounts <ayable +" #ncrease in 9ther :lient .illables "3
#ncrease in Accruals !0"5 #ncrease in 9ther :urrent Assets 5"1
#ncrease in :onv" ub" Debentures 31"0 #ncrease in %et *i4ed Assets !3"5
#ncrease in Def" :ompensation and ;eserves !!"0 #ncrease in 9ther Assets /"0
#ncrease in Acrruals <ost=;etirement //"5 #ncrease in #ntangibable Assets 3/"+ #ncrease in 9ther >iabilities 7"3 Decrease in >ong 6erm Debt 10"0
toc' #ssuance +"0 Dividends 7"+ Adustment in hareholders ?$uity (toc'
;epurchases, :urrency >osses, Assets write
offs)@ 173"+
#otal "&'$1 #otal "&'$1
@6here is not enough information in the case about the specifics of some of these transactions" e put them all together recogniBing that the
total change in shareholders e$uity is affected by retained earnings (difference between net income and dividends), stoc' repurchases, foreign
currency translations losses or gains and other adustments"
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Financial atios
6he first thing to note is that the company bills their customers and pays the media for theads placed" 6herefore, the company has a lot of receivables and payables" 9n average,commissions and fees to D&G are only 1/- of these billings"
6he current ratio is slightly lower than the industry median (1"04 vs" 1"14 for theindustry) and it has fluctuated very little over the past 5 years" A $uic' ratio does notma'e sense here because the firm does not have inventories" Average collection periodfluctuated without any particular trend, and it is lower than the industry (5! vs" +! days)"6otal debt=to=e$uity ratio is higher than the industry median ("/4 vs" 5"+4) 6his ratio isso high because it includes accounts payables (+7- of total liabilities)"6imes interest earned has increased over the period, reflecting a slight improvement inthe company8s ability to service" Cowever, it is well below the industry median (5"4 vs"1/"34)<rofitability has increased over the years and it is above the industry" <rofit before ta4esare "3- vs" /"1- for the industry" 6he company8s <? ratio has fluctuated over the years
and it is currently at !"14 vs" the 13"+4 industry median" (refer 6able !)
#able $ Financial atios
!
1991 1992 1993 1994 Industry
Liquidity Ratios
Current Ratio 1.05 1.09 1.10 1.06 1.1
Average collection period 51.42 45.65 38.48 42.15 52
Debt Ratios
Total Debtto!"uit# 6.98 6.20 $.43 6.89 4.5%T Debt & !nterpri'e (alue 0.11 0.12 0.14 0.14
%T Debt & Tangible A''et' 0.13 0.15 0.12 0.12
)ntere't *earing Debt & !*)T 2.$0 2.51 2.14 2.63
Coverage Ratios
Ti+e' )ntere't !arned ,!*)T&)ntere't- 4.44 4.09 4.68 4.61 13.8
Profitability
et /roit argin 4.$ 5.3 5.$ 5.6
/roit *eore Tae' & ale' 9.2 9.8 10.2 9.8 3.1
Market!alue Ratios
/&! Ratio 24.15 29.93 30.00 26.0$ 18.5
Dividend ield 0.35 0.31 0.28 0.33
P"# Ratios for Co$%etitors
oote7 Cone and *elding 18
)nterpublic roup 19
+nico+ roup 16
:// roup 2$
ean 20
edian 18.5
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*usiness isks
Cyclical risk E orldwide spending on advertising has increased in 15=+, drivingcompany8s revenues" Cowever, spending on advertising is highly correlated with thelevel of economic activity in a country" .ecause it is a discretionary e4pense it is one ofthe costs that companies cut first in the event of an economic turndown"
Seasonal risk E 6here is a moderate seasonality in the demand for advertising serviceswith an increase towards the year=end"
Currency risk E *oreign business account for +- of total commission and fees" D&Ghas no hedging strategy and incurs significant translation gainslosses when 2foreigncurrency e4change rate changes"
Uncertainty of the information technology development E Advertising agencies areaggressively pursuing participation in interactive communication an the internet" 6his is anew area for advertising and its future and development are uncertain"
Competition E 6he company is one of the three largest players in the industry, and thecompetition is intense" uccess is determined by the balance between efficient operationsand a creative edge"
Liquidity- Although they try to collect payments and pay at about the same time, a smallincrease in the gap of collections vs" payables could have a large effect on the company8sneed for cash"
Company specific risk - 6he company8s beta is 1"/ compared to 1"1 industry average"
) +o the eistin- means of financin- unduly restrict the company?
6he following table summariBes the past financing decisions of the company and itsimplications"
#able .$ /haracteristics of 0ast Financin-
/
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6he company still has 2133 of available credit on ban' lines, and they can negotiate230 additional" 9n the long=term debt instruments, the company agreed to certaincovenants that restrict additional indebtness and new investments" Cowever, this can bewaived by means of a higher interest rate and the investors are open to renegotiate"?.#6 #nterest e4pense is +"04, above the /4 theoretical benchmar' and reflecting
enough capacity to cover debt interest"9n the negative side, those who invested in the convertible debt are not very satisfiedwith the performance of their investment" #t is currently trading at 277"!+ per 2100 facevalue (the conversion price is 2113 and the stoc' is currently trading at 25)" *urthermore, the debt to e$uity ratio is currently "/ compared to 5"+ for the industry and >6debt to capitaliBation is 1!- vs" - for the industry" Debt service coverage ratiocalculated with ?.#6 is 0"/, but it should loo' better if calculated with ?.#6DA(unfortunately we could not find enough information on depreciation)"
5
#ype of Financin- *ank *orro1in- 2on-!term +ebt/on3ertible
Subordinated +ebt/ommon!Stock
#erm hort=term long=term loans!0=year (due arch
!01/)>ast issuance in 1!
4n3estor 5 2ender !/ ban's#nstitutional investors
(insurance companies)<ublic <ublic
0urpose
*inance a moderate
bulge in receivables at
year end and buildup
in assets
(ac$uisitions)"
*inancing specific
ac$uisitions or
investments
<ay down e4isting
debt and fund wor'ing
capital
*inance buildup in
current assets and
ac$uisitions and offset
foreign e4change
translation losses"
/ost <rime rate F 3"+-
*i4ed rate coupons in
the 3"!+- to 11"+-
range
+"7+-ubscription price
271"+
Amount 2/50 million 2!11 as of 15231 million
2+ million (1!
issuance)
/onditions 5
(estrictions 5
6ther
/onsiderations
ome secured with
assetsG some unsecured
but subect to loan
agreement" :ovenantsH
;estrictions on large
ac$uisitions, additional
indebtness, net worth
and investment in
fi4ed assets"
:onversion price
2113" :allable after
arch 1+" #nitial
call price 210+"7+
Cigher beta than the
industry (1"/ vs 1"1)
(elationship 1ithin3estors
ome concerns with
repurchase of stoc'"Ailling to increase
credit lines up to 25!0
million"
Ailling to renegotiate
a longer term subectto continued
profitability"
#nvestors are not very
happy with the
performance of thisinvestment" :urrently
trading at 277"!+ per
2100 face value
ince 1! the price
has fluctuated a lot(2/"7+ to 2111"1!
range)" %ow trading at
25"
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#n summary, D&G faces some restrictions as a conse$uence of its past financingdecisions, but we believe that the company will be able to finance the e4pansion proectand will have to choose among different alternatives"
+
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.) Analy7e the financin- alternati3es as to hich best fits +89’s situation$
6o answer this $uestion we provide two tablesH the first one describes the specifics ofeach alternative, and the second one is a discussion of the several criteria that should be
considered for capital structure and financing alternatives decision=ma'ing"
#able "$ /haracteristics of Future Financin- Alternati3es
#ype of Financin- *ank 2ines of /redit #erm 2oan +ebentures /ommon Stock
#erm hort=term 7 to 10 years !0 years
4n3estor 5 2ender ame ban's
<rivate placement =
same insurance
companies
<ublic offering <ublic offering
0urpose
/ost
<rimeF3"+- or
primeI0"+-F- if the
lines are increased
10"!+- for a 7=year
term and 10"7+- for a
10=year loan" >egal
costs F 2100 J"
Average interest rate
of e4isting loans F
10"7/-
10"+-" pread F !-
of the proceeds" >egal
costs F 2!0 J"
Average interest rate
on term loans F 10"-
hare price F 25"
nderpricing - to
10- F 2+7" to 0"!"
>egal costs F 2/+0 J
Amount
/onditions 5
(estrictions 5
6ther
/onsiderations
:urrent lines of 2/50
million, less 21+! used
F 2133 available"
Additional 230 million
can be negotiated, but
the rate will be higher
I0"+- " 6he company
also needs some
borrowing capacity for
emergencies" ?venwith the 230 increase
lines are not sufficient
to cover the needs"
Does not allow prepayment"
:ovenantsH
1):urrent ratio KF 1H1"
!) (.an' loansI>6
debt) :apitaliBation
LF7+-" /)
#ntangible
assetsLF25+0 " 5)
%o further indebtness"
+) Dividends%et profitLF/+-" )
>eases subect to
approval" ;ating will
fall from ... to .."
+ years deferred call
protection" in'ing
fund starting on year
10" ;e$uires waiver
from current lenders
(institutional investors)
of the term loans,
raising int rate to
10"- ";atings could fall from
.aa=! ... to .a=!
.. or .a=/ ..=
:onvertible debt
holders (2113
conversion price)
could protest if the
company issues stoc'
at that price"
?4pansion plan in outheast Asia and >atin America
2/00 million
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#able :$ /riteria for +ecision!;akin-
7
/riteria *ank 2ines of /redit #erm 2oan +ebentures /ommon Stock
<*4#!<0S Analysis
+ebt (atios
10"70- !1"- !1"- 10"70-
/"37 /"37 /"37 !"/1
7"!0 7"!0 7"!0 /"/1
/o3era-e (atios
!"+ !"7 !"7+ +"0+
0"!! 0"+7 0"+7 0"/
<rimeF3"+- or
primeI0"+-F- if the
lines are increased
10"!+- for a 7=year term
and 10"7+- for a 10=year
loan" >egal costs F 2100
J" Average interest rate of
e4isting loans F 10"7/-
10"+-" pread F !- of the
proceeds" >egal costs F
2!0 J" Average interest
rate on term loans F 10"-
hare price F 25"
nderpricing - to 10- F
2+7" to 0"!" >egal costs
F 2/+0 J
(atin-s
6he companyMs credit
rating could be
downgraded from ... to
.."
;atings could fall from
.aa=! ... to .a=! ..
or .a=/ ..=
6here is not enough
information to assess the
chance of a better credit
rating, but certainly it
should not be adusted
downward"
6hese are basically the direct costs of each type of financing in the form of interest rate, legal and out=of=poc'ete4penses"
<,plicit /osts
6his ratio measures the ability to cover not only interests but also principal payments" 6he formula is ?.#6
(#nterest I <rincipal payments(1=ta4 rate)" ;emember that principal payments are adusted by the ta4 rate
because they are not deductible " 6he number for .an' lines of credit is smaller because the we included the
whole amount of debt as a current maturity"
>6 Debt to
:apitaliBation
#nterest .earingDebt to ?.#6
Debt to ?$uity
6imes #nterest
?arned
Debt ervice
:overage
.oth the term loan and the debentures alternative increase substantially the >6 debt to capitaliBation ratio
6hese figures are the same for the three types of debt and contrast sharply with the ratio that the company
currently has of !"/1 (that would be maintained if the company goes with e$uity)"
All the ratios seem very high" Cowever, it is important to note that in this case debt includes the huge ammount
in accounts receivables" Any type of debt would increase this ratio to 7"!, but an e$uity offering would reduce it
significantly" 6he company currently has a "/ ratio compared with a 5"+ for the industry"
6his is ?.#6#nterest ?4pense" :urrently, the company has a +"0+ ratio that compers favorably to the industry
figure of /" A common stoc' issuance would not have any effect on this, but any 'ind of debt would reduce the
coverage of interests" %otice that the difference among the three types of debt comes from the different interest
rates"
nder the current scenario (21! proected ?.#6) the best alternative is e$uity" 6he indifference point
between .an' >ines and ?$uity is 2!0+ " .elow that e$uity is better, above 2!0+ debt is better" .ecause long
term debt has higher costs, the indiference point between debt and e$uity in this case is higher, 2!/+ " 9nly if
?.#6 is higher than 2!/+ it would be better to be financed with long term debt" 6he two long term debt
alternatives (term loans and debentures) are very simmilar in terms of costs" ee additional analysis and graph"
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#able :$ /riteria for +ecision!;akin-$ /ontinued=
6he ?.#6=?< analysis allows us to weight the costs of debt and e$uity for different
levels of ?.#6" #n the case of debt, the costs ta'e the form of interest e4pense that isreduction substracted from ?.#6" #n the case of e$uity, the company pays no interest onthat capital, so net income is higher, but the current shareholders are diluted, this meansthat the earnings per share could be higher or lower" #n general, we would e4pect that forlower levels of ?.#6 the company would be better off with e$uity and for higher levelsof ?.#6 a debt strategy would yield a higher ?<" *ollowing is the analysis for the fouralternatives that D&G is considering" 6he 'ey points are those levels of ?.#6 at whichthe company is indifferent between choosing debt and e$uity" nder the current scenario
3
/riteria *ank 2ines of /redit #erm 2oan +ebentures /ommon Stock
#imin-
6he #. e4pects interest
rates to raise and therefore
recommends to seiBe the
opportunity with a debt
issue as soon as possible"
6he president of the firm
argues that the stoc' is
currently undervalued
because the mar'et doesnMtunderstand the e4pansion
plan" #f they must sell stoc'
he says they should wait
until the price goes up"
Fle,ibility
Cigh" *or their short=term
nature, lines or credit
would obviously be the
most fle4ible means of
financing, because after
one year the company
could do practically
anything"
edium=>ow" ?ven
though a 6erm >oan has
less covenants than
Debentures, it still
seriously limits the
companyMs financing
ability"
>ow" .y issuing
debentures, the company
will be constrained in
numerous ways that limit
its future borrowing ability"
edium" *inancing with
e$uity has the advantage of
improving the D=? ratio"
*luctuations in capital
mar'ets could somewhat
restrict future decisions,
such as stoc' repurchases"
A-ency /osts
6he effect for commonstoc' is the opposite" .y
reducing ris' it reduces the
value of e$uity relative to
debt" 9n the other hand the
increased e$uity gives the
management some breadth
which might ma'e them
ta'e away focus from
efficiency"
#a,es %o ta4 shield"
Si-nalin-
#ncreasing the line of credit
will probably signal an
e4pected increase in
volume of operations,
since this is the main use of
this type of financing"
#ssuing long term debt has
the positive effect of
signaling an undervalued
stoc' as perceived by the
management"
Given that debentures are
mostly used by well
established companies, an
emission of them may have
a positive signaling effect"
#ssuing stoc' sends a bad
signal, because in theorythe company would not
issue stoc' if the
management feels the stoc'
is under=valued"
anagement argues that
the mar'et doesnMt
understand the plan to
grow the company"
ince the company is profitable and pays an high corporate ta4 rate (5/-), there is
a substantial ta4 shield in the three debt cases" 6hese efects are captured indirectly
in the ?.#6=?< analysis"
e can thin' of the value e$uity as being e$uivalent to a call on the value of thefirm" 6he higher the ris' the higher the value of the call" .y increasing debt level
the company becomes more ris'y" 6herefore having more ris' increases the value
of e$uity" .ut total value of a firm is constant (odigliani=iller)" 6herefore the
increased leverage reduces the value of debt" An offsetting effect is that the
increased leverage obligues stoc'holder management to be more careful and more
efficient because they constantly need to worry about servicing debt" #t is unclear
for this company which of both effects is more important (it depends more on
factors such as how ris' averse is the management or how much ris' there is of
moral haBard)"
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(21! proected ?.#6) the best alternative is e$uity" 6he indifference point between.an' >ines and ?$uity is 2!0+ " .elow 2!0+ e$uity is better, but above that point,debt is better" .ecause long=term debt has higher costs, the indifference point betweendebt and e$uity in this case is higher, 2!/+ " 9nly if ?.#6 is higher than 2!/+ it would be better to be financed with long term debt" 6he two long=term debt alternatives (term
loans and debentures) are very similar in terms of costs"
#able >$ <*4#!<0S Analysis
*ank 2ines
of /redit#erm 2oan +ebentures
/ommon
Stock
?.#6 !/+"+ !/+"+ !/+"+ !/+"+
#nterest on e4isting debt /3"1 /3"1 /3"1 /3"1
#nterest on new debt !7"0 /1"+ /1"3 =
?.6 170"5 1+" 1+"+ 17"5
6a4es 7/"/ 71"/ 71"! 35"
%et #ncome 7"1 5"+ 5"/ 11!"+
%umber of hares !" !" !" /!"1
?< /"1+ /"+!0 /"+1/ /"+03
#nterest ;ate - 10"+0- 10"!- %A
:ash %eed /00 /00 /00 /00
6a4 ;ate 5/-
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/hart 1$ <*4# <0S 4ndifference /hart
#he +ecision
s" :aidwell hoped to ma'e a recommendation to essrs" tein and aitley and to two
other members of the management committee by the end of ne4t wee'" he was mindfulof the need to retain some financial fle4ibility" 6o end up li'e aatchi & aatchi as ahighly ris'y company was not something that she would li'e to see as chief financialofficer" Cowever, she had only one voice in five on the matter" 6he NfinalO voice was thatof tein" Given management8s recommendation, it would be her tas' to present the matterto the board of directors at its ne4t meeting in five wee's" Although she had been amember of the board for over two years, one still needed to have structured, analytical bac'up for any management recommendation" 6o be less than thoroughly prepared wasunthin'able"
10
?.#6=?<
!"0
!"!
!"5
!"
!"3
/"0
/"!
/"5
/"
/"3
5"0
1+0 10 170 130 10 !00 !10 !!0 !/0 !50 !+0?.#6
? < )
.an' >ines of :redit
Debentures
:ommon toc'
6erm >oan