FIN 486 Week 3 Financing, Capital Structure and Risk Example

Paying for the Georgia Plant Without Losing the Rating: Debt, New Shares or Internal Cash for Lakeshore Packaging, Plus Fiber Price and Interest Rate Risk

[Student Name]

University of Phoenix

FIN/486: Strategic Financial Management

Week 3 Assignment

[Instructor Name]

[Date]

Lakeshore Packaging and all figures are composites written for a model paper; theories, rating practices and research findings come from the sources listed and are stated generally.

The composite molded fiber maker has approved a $180 million plant in Georgia, with most of the spending over the next 12 months. The company has $310 million of debt and $40 million of cash, so net debt of $270 million is about 1.5 times its $176 million of EBITDA. Its bonds are rated in the lower half of investment grade, which keeps its borrowing costs moderate and gives its restaurant customers confidence in a long-term supplier. The plant will be paid for once, but the way it is paid for will shape Lakeshore's flexibility for years. This paper chooses the financing and the risk program that goes with it.

The Funding Need

Beyond the $180 million plant, the ramp-up requires about $25 million of working capital over three years. Lakeshore expects to generate about $70 million of free cash flow a year from existing operations after dividends of $24 million, which can fund part of the need. Timing matters as much as the total: most of the plant spending falls in the next 12 months, while the plant's own cash flow does not turn positive until its second year.

Option One: All Debt

Issuing $180 million of ten-year notes at about 6.25 percent, close to what similar issuers recently paid, would raise net debt to about $450 million, or about 2.6 times current EBITDA, before the plant contributes anything. Interest would rise from about $17 million to about $28 million, and coverage of interest by operating income would fall from about 7 times to about 4.3 times. Rating agencies typically treat net debt near 3 times EBITDA as the edge of investment grade for a company of Lakeshore's size and business risk. Ratios would improve as the plant's earnings arrive in years two and three, but for at least a year Lakeshore would sit close to a downgrade.

Option Two: All Equity

Issuing about 4 million new shares at $45 would raise $180 million, keep net debt near 1.5 times and protect the rating. It would dilute existing holders by about 13 percent at a time when the plant contributes little earnings. Myers and Majluf (1984) showed that because managers know more than investors, a share issue can signal that managers believe the stock is overvalued, which often lowers the price on announcement. Lakeshore's managers believe the opposite.

Option Three: Debt Plus Internal Cash

Issuing $120 million of notes and funding the remaining $85 million of plant and working capital from internal cash flow over 18 months would raise net debt to about $390 million, about 2.2 times, peaking before the plant's earnings arrive and falling below 2 times by year three. Coverage would stay near 5 times. This follows the pecking order, using the company's own cash before borrowing and leaving new shares out entirely.

Why the Rating Matters

Kisgen (2006) found that firms near a change in credit rating issue less debt relative to equity than other firms, suggesting that managers value staying within a rating category because ratings affect borrowing costs, access to markets and relationships. For Lakeshore, a downgrade below investment grade would raise borrowing costs, could trigger supply contract reviews by chains that require financially strong vendors and would reduce flexibility for phase two. Graham and Harvey (2001) reported that when chief financial officers set debt levels, the two concerns they named most were keeping financial flexibility and protecting the credit rating.

Effects on the Cost of Capital and Earnings

At moderate debt levels, the weighted average cost of capital changes little: more debt adds cheaper after-tax funding but raises the return shareholders require. Option three moves the cost of capital from about 8.6 percent to about 8.5 percent. Earnings per share in year two would be about 4 percent higher under option one than option three, and about 9 percent lower under option two, but the extra earnings under all debt come with higher risk that the measure does not show.

The Recommendation

Option three balances cost, flexibility and the rating. It avoids dilution and a negative signal, keeps credit ratios within investment grade throughout and leaves room to borrow for phase two in year four if demand proves strong.

Managing Fiber Price Risk

Recycled fiber, mainly old corrugated containers, is Lakeshore's largest raw material cost, about 28 percent of revenue, and its price can swing by half in a year. Futures markets for recycled fiber are thin, so financial hedging is limited. After testing several approaches, Lakeshore will lock in about half of its expected fiber needs through two-year supply contracts with recyclers at fixed or capped prices and will add index-linked price adjustment clauses to new food service contracts, passing a share of fiber cost changes to customers within one quarter.

Managing Interest Rate Risk

The new notes will carry a fixed rate, so a rise in market rates during the plant's ramp cannot raise the cost of the borrowing that pays for it. Lakeshore's existing revolving credit, used for seasonal working capital, floats; it will keep floating-rate debt below 25 percent of total debt.

Why Hedge at All?

Froot et al. (1993) made the case that hedging pays off when it keeps internal cash available for a firm's best investments. For Lakeshore, a fiber price spike during the plant build would cut the internal cash in option three and force more borrowing at a bad moment. Protecting that cash flow is the purpose of the program.

A Policy Going Forward

The board adopted a target range for net debt of 1.5 to 2.5 times EBITDA, a commitment to stay investment grade and a rule that any share repurchases pause when net debt exceeds 2.5 times.

Conclusion

Funding the Georgia plant with $120 million of debt and internal cash keeps Lakeshore within investment grade, avoids dilution and a negative signal and preserves flexibility for phase two. Supply contracts and price clauses manage fiber risk, fixed-rate notes manage interest risk and a target range turns a one-time choice into a policy.

References

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1993). Risk management: Coordinating corporate investment and financing policies. The Journal of Finance, 48(5), 1629-1658. https://doi.org/10.1111/j.1540-6261.1993.tb05123.x

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Kisgen, D. J. (2006). Credit ratings and capital structure. The Journal of Finance, 61(3), 1035-1072. https://doi.org/10.1111/j.1540-6261.2006.00866.x

Myers, S. C., & Majluf, N. S. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13(2), 187-221. https://doi.org/10.1016/0304-405X(84)90023-0