Rosario Acero SA Case Study

8/10/2019 Rosario Acero SA Case Study

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Rosario Acero SA Case Study

Question 1: Why is Pablo Este considering obtaining long-term capital?

Pablo Este considered three purposes for obtaining the long term capital of 7.5 million.

The first purpose was to pay down the companys present working capital line of credit. In

theoretical term a line of credit basically means an amount of funds that are available from thebank for the ongoing working capital or the cash needs of a business. The amount that is raised is

often used for daily operations such as inventory purchase, purchase small equipment, manage

unexpected expenditures and to cover the cyclical business fluctuations. In case of Rosario Acero

the total amount needed to pay down as working capital line of credit is 4.8 million. The company

has maintained its line of credit with Banco de Sol of Buenos Aires. The line was maintained 2

percent higher than the average market rate since it was not backed by any collateral that is the

receivable and inventory rather was supported by personal guarantee and commercial real estate.

The second purpose of long term financing is to repay the long term debt. The long term debt that

the company has pursued will mature in next 6 months; therefore it is high time for the companyto make arrangements to pay its long term debts. The total amount of long term debt is $9,

75,000. This is also a form of credit which is purposefully used to purchase long term assets such as

buildings and heavy equipments. For any company to have healthy financial results, its long term

debt should be minimum. Therefore companies should try to keep them away from the debt

burden.

The third and final purpose of the long term financing is for capital improvement and general

purposes. In capital improvement a company basically tries to enhance or improve certain

property that increases the overall value of the company. The total amount detach for capital

improvement is $1,725,000.

Question 2: How will the two financing alternative affect the performance of the firm? Please

examine the financial forecasts contained in Exhibit 6 to Exhibit 12 in the case.

The performance of the firm could be evaluated through various financial ratios and valuation of the two

alternatives. The major financial ratios could be EPS (Earning per share), ROA (Return on Assets), ROE

(Return on Equity), Debt ratio, and Interest Coverage Ratio. The values and the interpretation for two

alternatives are as follows:

1.EPS (Earning per Share):

EPS under Private Placement with Warrants

1996 1997 1998 1999 2000 2001 2002

$7.57 $4.96 $6.04 $7.29 $8.70 $10.28 $12.06

EPS under Equity Shares

1996 1997 1998 1999 2000 2001 2002

$7.57 $1.72 $1.99 $2.29 $2.64 $3.02 $3.45

EPS is computed by dividing earnings after interest and taxes by the number of shares outstanding. We

can see that with private placement with warrants, companies' EPS is in increasing trend from 1997 to


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2002. With the issue of debt, it is reasonable to increase the EPS because number of shares outstanding

will remain constant. On the contrary, with the issuance of equity shares, though it is increasing trend but

less than in terms of debt issuance. Keeping other things constant, debt issuance could add value to the

firm through high EPS.

2. ROA (Return on Assets):

ROA under Private Placement with Warrants

1996 1997 1998 1999 2000 2001 2002

7.93% 4.06% 4.60% 5.16% 5.70% 6.24% 6.76%

ROA under Equity Shares

1996 1997 1998 1999 2000 2001 2002

7.93% 6.44% 6.93% 7.43% 7.91% 8.38% 8.84%

ROA of any firm is a measure of profit per dollar of assets. It is obtained by dividing net income by the

total assets of the firm. From the above calculation, we can see that either use of debt or equity has no anysuch large effect on the profit per dollar of assets of Rosario.

3. ROE (Return on Equity):

ROE under Private Placement with Warrants

1996 1997 1998 1999 2000 2001 2002

49.0% 24.3% 22.8% 21.6% 20.5% 19.5% 18.6%

ROE under Equity Shares

1996 1997 1998 1999 2000 2001 2002

49.0% 14.2% 14.1% 14.0% 13.8% 13.7% 13.5%

ROE is a measure of how the stockholders fared during the year. ROE is, in an accounting sense, the true

bottom line measure of performance. It is calculated by dividing net income by the total equity of any

company. We can see that, with the use of either debt or equity does not have any greater effect on ROE.

Instead, in both the cases ROE has decreased in comparison to the ROE of 49% of the year 1996.

Valuation of two alternatives using Discounted Cash Flow Method:

We have computed the value of both alternatives using the average unlevered beta from the Rosario's

major competitors. The competitors are Acero Dali S.A. (AD), Colon S.A. (CSA), Greco Acero (GA), and

Velasguez S.A. (VAZ). We have not considered Picasso Acero S.A (PI) to calculate the unlevered beta,

since this company is going through losses in the most recent years.

We have used similar method for both the private placement with warrants and equity shares to come up

with the intrinsic price of share of Rosario. With the use of unlevered beta of competitors, Rosarios levered

beta has been calculated. The same levered beta, with addition to risk free rate of 5.7% (3-month T-bill

rate, case Exhibit 13), and risk premium of 4.54%, has been used to come up with return on equity (Re) for

the firm by using equity as an alternative. We found risk premium by calculating nominal growth rate anddeducting risk free rate from this nominal rate. We have assumed that the stock price grows with the

growth in economic activity such as GDP (6%). With the use of various cost of equity in each year from

1997-1998, and a constant cost of debt of 10.5% (Exhibit 14), we have computed the WACC (Weighted


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Average Cost of Capital) for the company in each year. Then, these WACC has been averaged and used to

discount the free cash flow in each year. Finally, we come up with the fair price per share of $95.77 for the

Rosario's stock. (Calculation in Annex 1)

With the same procedure and assumptions as in the case of issuance of equity, we have valued the debt

for the company. The only difference is the use of cost of debt as the proportion of old as well as new

debt. So in this case the cost of debt varies in each year. There is different WACC in this case which has

been used to discount the forecasted cash flow. The fair price of stock comes to be a negative $29.20 iffirm uses a debt with warrants financing. (Calculation in Annex 2)

Question 3: What are the principal risks the firm faces? Under some reasonable downside scenario, could

Rosario Acero continue to service its debt?

The principal risks that Rosario Acero S.A. faces are as follows:

Debt-servicing risk: The forecasts resulting from the issue of debt gives following results:

Projected

1997 1998 1999 2000 2001 2002 2003 2004

Free Cash Flow 1.41 1.20 1.33 1.46 1.61 1.78 1.96 2.16

Less Interest Payments (1.71) (1.68) (1.63) (1.56) (1.48) (1.38) (1.39) (1.52)

Interest Tax Shield 0.58 0.57 0.55 0.53 0.50 0.47 0.47 0.52

Less Principal Payment (1.88) (5.63)

Free Cash Flow to Equity Holders 0.29 0.09 0.25 0.43 0.63 0.87 (0.83) (4.46)

The above table shows that if Acero takeas on a private placement of eight-year notes, the cash flows are

not enough to cover the payments of principal in year 2003 and 2004. As a result equity holders areprovided with negative free cash flows. Therefore, the firm will need to make arrangements for

refinancing for meeting the principal payment obligation.

Single supplier: Acero relies on only one primary source for the scrap metal used in its production of rolls

and castings located in Buenos Aires. The image of Acero will be deteriorated if the supplier is not able to

supply. As a result, Acero will lose its customers and sales.

Market fluctuation risk: The stock market of Argentina is tied up with South American markets. So, the

volatility in South American markets can harm the Argentinas market.(Example: Mexican peso crisis had

harmed the Argentinas market back in 1994)

Strong covenant risk:The debt covenants require Rosario Acero to maintain its EBIT coverage of at least

2.0. This could be a greater risk for the firm in reaching the level of EBIT.

In the case of reasonable downside scenario, the real GNP grows only by 1.5% with an inflation rate of

2.5%, yielding a real GNP growth rate of 4%. The forecast for annual rates of inflation is between 2.5%

and 4% and for Real Gross National Product (GNP) is 1.5% to 6%.

Rosario Acero financial statements projections have been based on a revenue growth rate of 10.3%. Lets

assume that the sales projections have been based on optimistic forecasts of the economys growth. As

per an optimistic projection, GNP growth rate will be 10%. ( 6% real GNP growth +4% inflation). From this

we can inferred that when GNP growth rate = 4%, sales growth rate =4.12% on the basis of GNP growth

rate= 10%, sales growth rate =10.3%


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The interest coverage ratio is still higher than 2 times for each of the forecast period even we use the sales

growth rate of 4%,

Sales growth rate of 4.21%

Actual Projected

1996 1997 1998 1999 2000 2001 2002Revenues 34.80 36.23 37.73 39.28 40.90 42.58 44.34

Cost of Goods Sold -27.65 -28.26 -29.43 -30.64 -31.90 -33.22 -34.58

Selling, Generall, & Admin. -3.96 -4.71 -4.90 -5.11 -5.32 -5.54 -5.76

Earnings Before Interest and

Taxes 3.19 3.26 3.40 3.54 3.68 3.83 3.99

Interest (Notes and Old Loans)(1) -1.10 -0.65 -0.55 -0.42 -0.27 -0.12 0.06

Interest (New Loan @ 13%) -0.98 -0.98 -0.98 -0.98 -0.98 -0.98

Profit Before Taxes 2.09 1.63 1.87 2.14 2.43 2.74 3.08

Taxes 0.00 -0.56 -0.64 -0.73 -0.83 -0.93 -1.05

Profit After Taxes 2.09 1.08 1.24 1.41 1.60 1.81 2.03

Profit With Extraord. Item 1.76

Earnings per Share 7.57 4.63 5.30 6.07 6.89 7.77 8.71

EBIT/Interest 2.90 2.00 2.23 2.54 2.95 3.51 4.36

From the table, it can be seen that Acero would still have ability to continue servicing its debt under the

downside scenario (sales growth rate of 4.21%)

Question 4: From Rosarios standpoint, are the terms of the notes and warrants package competitive

and/or attractive?

Rosario Acero S.A had been planning to issue senior notes with non detachable warrants; notes being

issued at interest rate of 13% per annum payable semi-annually. The case also gives the base lending rate

in the economy as 8.5% plus 2%. Hence looking it from the companys perspective, the notes are not

attractive as the Rosarios coupon rate is 2.5 % higher than the base rate. Although this seems attractive

from investors perspective, it is not from the standpoint of the company. As also highlighted in Exhibit 14;

many companies in the similar industry are issuing debt at a rate higher than Rosario SA.

Further, the terms and conditions of issuance prohibit the company to redeem it before maturity. That is

the company cannot call the notes before 7th year. Such terms and conditions although protects the

potential investors from increasing interest rate risk, it will not allow the company to take the advantage

of potential decline of interest rate in the economy.

Warrants is a certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a

specific amount of securities at a specific price, usually above the current market price at the time of

issuance, for an extended period, anywhere from a few years to forever. In the case that the price of the

security rises to above that of the warrant's exercise price, then the investor can buy the security at the

warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain

unused.


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Generally, the attachment of warrants with the notes is viewed as a sweetener which increases the returns

for the investors. The inclusions of warrants also benefit the company as it helps to reduce the coupon

payments in the notes. But this is not the same in the given case. The inclusion of warrants has no changes

in the companys coupon rates. The notes were being issued at high coupon rates of 13. Similarly, issue of

warrants with notes threatens the existing shareholders position in the company, which might get diluted

if the warrants are exercised.

Question 5: As for the possible equity issue, would an offering price of $9 per share be fair?

Before computing the fair value for the Rosario there are certain assumptions to be made for the

company. We are not provided with clear information regarding expected growth. So, we have assumed

the growth rate to be 6%. It is assumed that the stock market reflects the economy, but we have included

the impact of inflation rate as 4% in our computation.

By sticking with this assumption we compute the fair value for Rosario. The fair value for the company is

$95.78 which is quite higher than the companys offered value.

Question 6: Which course of action should Este adopt? In preparing your recommendation, use the

FRICTO framework to identify the trade-offs between the two alternatives. (FRICTO stands for

flexibility, risk, income, control, timing, and other.)

From our analysis we have come to find that , the offer (IPO) price of $9 per share of Rosario stock

would much lesser than its fair (intrinsic) price of $95.77. Similarly, Rosario's intrinsic equity value willbe negative by $29.19 per share if the new debt with warrants is used as a financing option. So we

have decided to g for IPO rather than short notes with warrants.

The FRICTO analysis is as follows:

Flexibility:When warrant is used the it may use up the firms debt capacity, thus precluding debt

as a financing option in future years to meet the firms anticipated future financing requirements. .

Sometimes the need for additional capital in the future is for unforeseen reasons, such as a sudden

investment opportunity or a financial crisis due to a severe economic downturn. So issuing

warrants does not provide flexibility to the company. But issuance of IPO would be more flexible.The EPS produced are forecasted to be higher and the firm would maintain most of its flexibility

due to it. By becoming a publicly traded company a business can take advantage of new, larger

opportunities and can start working towards incorporation and even worldwide expansion. IPO

gives a company fast access to public capital. Even though public offering can be costly and time

consuming, the tradeoffs are very appealing to companies

Risk: IPOs are also a relatively low risk for businesses and have the potential for huge gains and for

huge opportunities. The more investors wish to invest in a company, the more the company stands

to or from IPOs and other stock offerings. The risk associated with debt is less than that associated

with equity financing . If one plans on exercising the warrant he must do so before the expiration

date. The more time remaining until expiry, the more time for the underlying security to

appreciate, which, in turn, will increase the price of the warrant (unless it depreciates).


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Income: For the investor, IPOs are attractive mainly because they may be undervalued. Initially, to

make IPOs more attractive, many companies will offer their initial public offering at a low rate. This

helps to encourage investors, and investors will often buy IPOs, thinking that the new company or

the newly public company will be the next big thing with a huge profit margin. As prices grow and

demand for the IPOs grows, early investors stand to make a lot of profit -- and very quickly. So

IPOs are good sources of income. Because no additional interest is paid, common stock financing

always produces higher earnings after taxes than debt. However, debt financing usually (although

not always under all conditions) produces higher ROE and EPS.

If interest rates increase after Rosario issues the bonds, Rosario would be set in on a fixed lower

rate, which means that they would need to pay out less each period to its bondholders. However,

the improving economy may also favor the equity option because Rosario will most likely receive

more than his asking share price as the stock price increases. Overall, the debt financing option

seems better for Rosario Acero.

Control: The forecasted higher EPS also helps the firm not give up its control. Issuance of warrant

does not give the warrant holders voting rights whereas that of IPOs gives the shareholders the

voting rights. In this case warrants might have better benefit in terms of the managements controlover the firm.

Timing: As the case describes that the economy of the country has been gaining better heights

after the Mexican Peso crash. the stock market had rebounded from the Tequila effect of the Peso

crash. The Merval index has risen over the previous three years, suggesting a growing optimism

among the equity investors in Argentina .The market of IPO seemed to be rising though the

volume is still low comparatively. Under such circumstances issuance of IPO would have better

tradeoff than warrants. Further, debt financing might require high interest payments. Moreover,

most of the companies issuing debts in South America have been rated below investment grade.

Due to this fact too it would not be wise to go for debt financing.

Other:PabloEste himself is concerned about the liquidity of his investments in the firm. He along

with the other equity investors feels the need to increase the marketability of Rosarios common

stock. Under such circumstances it would be better to go for IPO as well.

Annex 1:

Computation of fair price of stock using Equity financing

Competitors AD CSA GA VAZLevered Beta 1.35 1.05 1.00 1.15

D/E ratio 0.7165 1.5529 0.4444 0.2797

Tax rate 0.34 0.34 0.34 0.34

Multiplier 1.4729 2.0249 1.2933 1.1845

Unlevered Beta 0.9165 0.5185 0.7732 0.9708

Avg. Unlevered Beta 0.79477

Real growth 0.06

Inflation 4%

Nominal Growth rate 0.1024

Rosario 1997 1998 1999 2000 2001 2002

Unlevered Beta 0.7947 0.7947 0.7947 0.7947 0.7947 0.7947


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D/E ratio 1.1984 1.0315 0.8827 0.7503 0.6330 0.5289

Multiplier 1.7909 1.6808 1.5826 1.4952 1.4178 1.3491

Levered Beta 1.42339 1.3358 1.2577 1.1883 1.1267 1.0722

Risk free rate 5.7% 5.7% 5.7% 5.7% 5.7% 5.7%

Risk Premium 4.54% 4.54% 4.54% 4.54% 4.54% 4.54%

Re 0.1216 0.1176 0.1141 0.1110 0.1082 0.1057

D/A

0.4549 0.4922 0.5312 0.5713 0.6124 0.6541

E/A

0.5451 0.5078 0.4688 0.4287 0.3876 0.3459

Cost of

equity 0.1216 0.1176 0.1141 0.1110 0.1082 0.1057

Cost of

debt

0.105 0.105 0.105 0.105 0.105 0.105

WACC

0.0978 0.0938 0.0903 0.0872 0.0844 0.0819

Average

WACC 0.0892

1997 1998 1999 2000 2001 2002

Free Cash Flow

1.4135 1.2017 1.3255 1.4620

1.6126 1.7787

Discounted FCF

1.2977 1.0129 1.0257 1.0386

1.0518

1.0651

FCF 2002

1.7787

Assumed growth rate 6%

WACC

0.0892

Value of all future FCFs on

2002 64.5031

PV of all future FCFs

38.6246

PV of Rosario on 1996 (end)

45.1164

Rosario's total liabilities in

1996

22.8

Value of Rosario's equity in

1996 22.3164

No. of stock outstanding 233000

Fair price per share

95.7784


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Annex 2:

Calculation of fair price per share using debt with warrant financing

Peer Firms AD CSA GA VAZ

Levered Beta 1.35 1.05 1.00 1.15

D/E ratio 0.7165 1.5529 0.4444 0.2797

Tax rate 0.34 0.34 0.34 0.34

Multiplier 1.4729 2.0249 1.2933 1.1846

Unlevered Beta 0.9166 0.5185 0.7732 0.9708


Rosario 1997 1998 1999 2000 2001 2002

Unlevered Beta 0.7948 0.7948 0.7948 0.7948 0.7948 0.7948

D/E ratio 4.9788 3.9618 3.1901 2.5947 2.1276 1.7556

Multiplier 4.2860 3.6148 3.1055 2.7125 2.4042 2.1587

Levered Beta 3.4064 2.8729 2.4681 2.1558 1.9108 1.7157

Real growth 0.06

Inflation 4%

Nominal Growth

rate

0.1024

Risk free rate 0.057 0.057 0.057 0.057 0.057 0.057

Risk Premium 0.0454 0.0454 0.0454 0.0454 0.0454 0.0454

Re 0.21170.1874

0.1691 0.1549 0.1438 0.1349

D/A

0.1673 0.2015

0.2387

0.2782 0.3197

0.3629

E/A

0.8327 0.7985

0.7613

0.7218 0.6803

0.6371

Cost of equity

0.2117 0.1874

0.1691

0.1549 0.1438

0.1349

Cost of debt

0.1288 0.1293

0.1302

0.1315 0.1336

0.1370

WACC

0.1905 0.1669

0.1492

0.1359 0.1260

0.1187

Average WACC 0.1479

Working notes:

Old Debt

1997 1998 1999 2000 2001 2002

Amount $6.66 $6.39 $5.92 $5.23 $4.29 $3.06

Percentage of total debt 47% 46% 44% 41% 36% 29%

Cost 0.105

New debt


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Amount 1997 1998 1999 2000 2001 2002

Percentage of total debt 7.50 7.50 7.50 7.50 7.50 7.50

Cost 53% 54% 56% 59% 64% 71%

0.13

1997 1998 1999 2000 2001 2002

Free Cash Flow 1.4135 1.2017 1.3255 1.4620 1.6126 1.7787

Discounted FCF 1.2314 0.9120 0.8764 0.8421 0.8092 0.7776

FCF 2002 1.7787

Assumed growth rate 6%

WACC 0.1479

Value of all future FCFs on

2002 21.4572

PV of all future FCFs 9.3804

PV of Rosario on 1996 (end) 14.8292

Rosario's total liabilities in

1996 22.8

Value of Rosario's equity in

1996 (7.9708)


Fair price per share (29.1972)


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Annex 3: Calculation of Fair price of share under different assumptions

Peer Firms AD CSA GA VAZ

Levered Beta 1.35 1.05 1.00 1.15

D/E ratio 0.7165 1.5529 0.4444 0.2797

Tax rate 0.34 0.34 0.34 0.34

Unlevered Beta 0.916552872 0.518534 0.773196 0.970808


Rosario 1997 1998 1999 2000 2001 2002

Unlevered Beta 0.794772535 0.794773 0.794773 0.794773 0.794773 0.794773

D/E ratio 1.1984 1.0315 0.8827 0.7503 0.6330 0.5289

Levered Beta 1.42339176 1.335861 1.257768 1.18836 1.12679 1.072203

Risk free rate 0.057 0.057 0.057 0.057 0.057 0.057

Risk Premium 0.0454 0.0454 0.0454 0.0454 0.0454 0.0454

Re 0.121621986 0.117648 0.114103 0.110952 0.108156 0.105678

D/A 0.454876803 0.49224 0.531165 0.571319 0.612386 0.654069

E/A 0.545123197 0.50776 0.468835 0.428681 0.387614 0.345931Cost of equity 0.121621986 0.117648 0.114103 0.110952 0.108156 0.105678

Cost of debt 0.105 0.105 0.105 0.105 0.105 0.105

Cost of debt (after tax) 0.0693 0.0693 0.0693 0.0693 0.0693 0.0693

WACC 0.097821928 0.093849 0.090305 0.087155 0.084361 0.081884

Average WACC 0.089229491

1997 1998 1999 2000 2001 2002

Free Cash Flow 1.413478032 1.201694 1.325469 1.461992 1.612577 1.778673

Discounted FCF 1.297686157 1.012873 1.025679 1.038646 1.051777 1.065074

FCF 2002 1.778672702

Assumed growth rate 0.06

WACC 0.089229491

Value of all future FCFs on 2002 64.50311068

PV of all future FCFs 38.62462818

PV of Rosario on 1996 (end) 45.11636282Rosario's total liabilities in 1996 (end) 22.8

Value of Rosario's equity in 1996

(end) 22.31636282


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Fair price per share 95.77838118

Assumption: FCF after 2002 grows at 6%

Hence, the offer (IPO) price of $9 per share of Rosario stock would be much lesser than its fair (intrinsic)price

Real growth rate 6%

Inflation 4%

Nominal growth rate 0.1024


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Class Answers

What is the problem with the company?

Wanted capital but didnt know how to raise it

Need the capital because in 93, broke away from the Parent and made losses in 95 period of

turmoil

o Labour unrest

o

Took on huge debt in the beginningo The market was also in a slump in Argentina no ready customer base

o Good things: companies within the trade grew opportunity for greater demand thus

needs capital to satisfy the potential demand

1. Why is Rosario considering obtaining long term capital

a. Expansion gone through teething stages of breaking away from parent

b. Further growth needs more capital capital intensive industry

2. How will the two financial alternatives affect the performance of the firm?

3. What are the principal risks the firm faces?

4.

Are the terms of the notes and warrants package competitive and/or attractive?5. As for the possible equity issue, would an offering price of $9 per share be fair?

6. Which course of action should Este adopt?

Mix of classes of capital 1996 1994

Liabilities/equity 6.3 28.6

(debt+notes)/equity 4.1

EBIT/interest 2.9 1.8

EBIT/(interest + amort) 1.9

The debt ratio is still high, the improvement in the interest coverage ratio could be seen as a sign of amarginally better risk exposure (but look at the market trends and industry trends as well

When calculating wacc, assumed the target capital structure was current capital structure

The additional debt financing (tax shield) and dilution effect

Downsides of going for debt huge risks. Economic environment could be right due to trade union. Debtreduces flexibility. Owners want liquidity of their investment through a share option

Rosario Acero SA Case Study

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