Chapter 6 Problem 14
Dec09 Dec08 Dec07 Dec06 Dec05
Sales 30,052$ 28,374$ 26,858$ 25,477$ 24,455$
Cost of Goods Sold 24,826 24,023 22,480 21,448 20,391
Gross Profit 5,226 4,351 4,378 4,029 4,064
Depreciation 1,425 1,416 1,426 1,391 1,374
Operating Profit 3,801 2,935 2,952 2,638 2,690
Interest Expense 1,987 2,021 2,215 955 655
Non-Operating Income/Expense 188 256 661 179 412
Pretax Income 2,002 1,170 1,398 1,862 2,327
Total Income Taxes 627 268 316 625 725
Minority Interest 321 229 208 201 178
Net Income 1,054$ 673$ 874$ 1,036$ 1,424$
ASSETS Dec09 Dec08 Dec07 Dec06 Dec05
Cash & Equivalents 312$ 465$ 393$ 634$ 336$
Net Receivables 3,692 3,780 3,895 3,705 3,332
Inventories 802 737 710 669 616
Other Current Assets 1,771 1,319 1,207 1,070 931
Total Current Assets 6,577 6,301 6,205 6,078 5,215
Gross Plant, Property & Equipment 24,669 23,714 22,579 21,907 20,818
Accumulated Depreciation 13,242 12,185 11,137 10,238 9,439
Net Plant, Property & Equipment 11,427 11,529 11,442 11,669 11,379
Investments at Equity 853 842 688 679 627
Other Investments 1,166 1,422 1,669 1,886 2,134
Intangibles 2,577 2,580 2,629 2,601 2,626
Deferred Charges 418 458 539 614 85
a. What were HCA’s liabilities-to-assets ratios and times-interest-earned ratios in the years 2005 through 2009?
c. How volatile have HCA’s cash flows been over the period 2005 – 2009?
e. HCA is the largest private operator of health care facilities in the world with hundrd of facilities in over 20 states. In
2006, private equity buyers took the company private in a $31.6 billion acquisition. In broad terms how costly do you think
financial distress would be to HCA if it began to appear the company might be having difficulty servicing its debt? Why?
f. In late 2010 HCA announced an intended dividend recapitalization in which it would pay a $2 billion dividend to
shareholders financed in large part by a $1.53 billion bond offering. At an interest rate of 6 percent, how would the added
debt have affected HCA’s times-interest-earned ratio in 2009?
d. Calculate HCA’s return on invested capital (ROIC) in the years 2005 – 2009.
HCA INC
ANNUAL INCOME STATEMENT
($ MILLIONS, EXCEPT PER SHARE)
ANNUAL BALANCE SHEET
b. What percentage decline in EBIT could HCA have suffered each year between 2005 and 2009 before the
company would have been unable to make interest payments out of operating earnings, where operating earnings
is defined as EBIT?
g. Please comment on HCA’s capital structure. Is its 2009 debt level prudent? Is it smart to add another $1.53 billion to this
total? Why, or why not?
Other Assets 1,113 1,148 853 148 159
TOTAL ASSETS 24,131 24,280 24,025 23,675 22,225
LIABILITIES
Long Term Debt Due In One Year 846 404 308 293 586
Accounts Payable 1,460 1,370 1,370 1,415 1,484
Taxes Payable – 224 190 – –
Accrued Expenses 2,007 1,912 1,981 1,868 1,825
Total Current Liabilities 4,313 3,910 3,849 3,576 3,895
Long Term Debt 24,824 26,585 27,000 28,115 9,889
Deferred Taxes – – – 390 830
Minority Interest 1,008 995 938 907 828
Other Liabilities 2,825 2,890 2,612 1,936 1,920
TOTAL LIABILITIES 32,970 34,380 34,399 34,924 17,362
Preferred Stock 147 155 164 125 –
Common Stock 1 1 1 1 4
Capital Surplus 226 165 112 – –
Retained Earnings (9,213) (10,421) (10,651) (11,375) 4,859
Common Equity (8,986) (10,255) (10,538) (11,374) 4,863
TOTAL EQUITY (8,839) (10,100) (10,374) (11,249) 4,863
TOTAL LIABILITIES & EQUITY 24,131$ 24,280$ 24,025$ 23,675$ 22,225$
Chapter 6 Problem 14 Suggested Answers
Questions:
Suggested Answers
Dec09 Dec08 Dec07 Dec06 Dec05
a. Liabilities/assets 1.37 1.42 1.43 1.48 0.78
Times interest earned 2.01 1.58 1.63 2.95 4.55 (EBIT = Pretax income+ Interest expense)
b. Percent EBIT can fall 50% 37% 39% 66% 78%
c. Annual % change in EBIT 25% -12% 28% -6%
d. ROIC 15.4% 13.8% 15.6% 10.4% 12.7%
f`. Times interest earned after new debt 1.92 1.51 1.57 2.69 3.99
Dec09 Dec08 Dec07 Dec06 Dec05
Sales 30,052$ 28,374$ 26,858$ 25,477$ 24,455$
Cost of Goods Sold 24,826 24,023 22,480 21,448 20,391
Gross Profit 5,226 4,351 4,378 4,029 4,064
Depreciation 1,425 1,416 1,426 1,391 1,374
Operating Profit 3,801 2,935 2,952 2,638 2,690
Interest Expense 1,987 2,021 2,215 955 655
Non-Operating Income/Expense 188 256 661 179 412
Pretax Income 2,002 1,170 1,398 1,862 2,327
Total Income Taxes 627 268 316 625 725
Minority Interest 321 229 208 201 178
Net Income 1,054$ 673$ 874$ 1,036$ 1,424$
ASSETS Dec09 Dec08 Dec07 Dec06 Dec05
Cash & Equivalents 312$ 465$ 393$ 634$ 336$
g. Please comment on HCA’s capital structure. Is its 2009 debt level prudent? Is it smart to add another $1.53 billion to
this total? Why, or why not?
HCA INC
ANNUAL INCOME STATEMENT
($ MILLIONS, EXCEPT PER SHARE)
ANNUAL BALANCE SHEET
e. Health care facilities should not be especially susceptible to the business cycle. Some health care is discretionary but
much is not. The company’s product is not a durable good, so concerns about parts and maintenance are not relevant.
g. By conventional balance sheet standards, HCA’s debt load is outrageously high. Liabilities exceed assets by a wide
margin every year. Yet by cash flow standards, debt looks much more reasonable. Interest coverage is greater than 1
every year, although the coverage ratio in 2008 of 1.58 is modest compared to a cross-section of US firms. Looking at the
stability of HCA’s cash flows in recent years provides additional comfort. The largest year to year decline was 12 percent
in the face of a very large recession, a figure that is less than 1/3rd the EBIT decline the company could suffer while still
maintaining an interest coverage of 1.0. My assessment that HCA would suffer only modest costs of financial distress
adds further to a belief HCA’s current capital structure is not overly aggressive. I am also impressed by the ROIC’s
consistently above 10 percent. HCA is a money machine. Finally, the addition of another $1.53 billion to the debt pile at
6 percent interest has a quite modest effect on the coverage ratios and does not change my overall conclusion that while
aggressive HCA’s capital structure is not unreasonable.
f. In late 2010 HCA announced an intended dividend recapitalization in which it would pay a $2 billion dividend to
shareholders financed in large part by a $1.53 billion bond offering. At an interest rate of 6 percent, how would the added
debt have affected HCA’s times-interest-earned ratio in 2009?
a. What were HCA’s liabilities-to-assets ratios and times-interest-earned ratios in the years 2005 through 2009?
b. What percentage decline in EBIT could HCA have suffered each year between 2005 and 2009 before the
company would have been unable to make interest payments out of operating earnings, where operating earnings
is defined as EBIT?
c. How volatile have HCA’s cash flows been over the period 2005 – 2009?
d. Calculate HCA’s return on invested capital (ROIC) in the years 2005 – 2009.
e. HCA is the largest private operator of health care facilities in the world with one hundred of facilities in over 20 states.
In 2006, private equity buyers took the company private in a $31.6 billion acquisition. In broad terms how costly do you
think financial distress would be to HCA if it began to appear the company might be having difficulty servicing its debt?
Why?
Net Receivables 3,692 3,780 3,895 3,705 3,332
Inventories 802 737 710 669 616
Other Current Assets 1,771 1,319 1,207 1,070 931
Total Current Assets 6,577 6,301 6,205 6,078 5,215
Gross Plant, Property & Equipment 24,669 23,714 22,579 21,907 20,818
Accumulated Depreciation 13,242 12,185 11,137 10,238 9,439
Net Plant, Property & Equipment 11,427 11,529 11,442 11,669 11,379
Investments at Equity 853 842 688 679 627
Other Investments 1,166 1,422 1,669 1,886 2,134
Intangibles 2,577 2,580 2,629 2,601 2,626
Deferred Charges 418 458 539 614 85
Other Assets 1,113 1,148 853 148 159
TOTAL ASSETS 24,131 24,280 24,025 23,675 22,225
LIABILITIES
Long Term Debt Due In One Year 846 404 308 293 586
Accounts Payable 1,460 1,370 1,370 1,415 1,484
Taxes Payable – 224 190 – –
Accrued Expenses 2,007 1,912 1,981 1,868 1,825
Total Current Liabilities 4,313 3,910 3,849 3,576 3,895
Long Term Debt 24,824 26,585 27,000 28,115 9,889
Deferred Taxes – – – 390 830
Minority Interest 1,008 995 938 907 828
Other Liabilities 2,825 2,890 2,612 1,936 1,920
TOTAL LIABILITIES 32,970 34,380 34,399 34,924 17,362
Preferred Stock 147 155 164 125 –
Common Stock 1 1 1 1 4
Capital Surplus 226 165 112 – –
Retained Earnings (9,213) (10,421) (10,651) (11,375) 4,859
Common Equity (8,986) (10,255) (10,538) (11,374) 4,863
TOTAL EQUITY (8,839) (10,100) (10,374) (11,249) 4,863
TOTAL LIABILITIES & EQUITY 24,131$ 24,280$ 24,025$ 23,675$ 22,225$
b.
d.
g.
How would you assess Avon’s business risk? Setting aside the way the company is financed, how significant are the marketplace risks Avon faces; how uncertain are the
company’s future operating cash flows? What does your assessment of Avon’s business risk suggest about the level of financial leverage the company can prudently
support?
How big a threat would it be to Avon if the company took on too much debt and had difficulty servicing it? How costly would financial distress be to Avon? Explain.
Based on your analysis and any other considerations you think relevant, is Avon heavily or modestly indebted? Should the company acquire more debt, or shed existing
debt? Why?
What was the book value of Avon’s shareholders’ equity from 2001 to 2003? What were Avon’s liabilities-to-assets and times-interest-earned ratios in these years? (Use
Pretax Income plus Interest Expense as EBIT.) What do these figures suggest about Avon’s use of financial leverage? Consulting Table 6-5 in the text, what bond rating
would Avon have in 2002 if the rating were based solely on the firm’s coverage ratio?
What percentage decline in EBIT could Avon have suffered in each year before Avon would have been unable to make its interest payments out of operating income?
Assuming a 35 percent corporate tax rate, and 2002 earnings before interest and taxes of $895 million, by how much did Avon’s $60 million interest expense reduce
taxes?
Answer question (a) and (b) again for 2002 assuming the company had borrowed an additional $3 billion in debt at 8 percent interest at the start of the year and
distributed the proceeds to shareholders as a special dividend. You may ignore the effect of added interest expense on Avon’s balance sheet. Might shareholders benefit
from such an increase in financial leverage? Explain.
Chapter 6 Problem 15 Suggested Answers
Suggested Answers:
2001 2002 2003
Shareholders’ equity ($75) ($128) $371
Liabilities-to-assets ratio 1.02 1.04 0.90
Times-interest-earned ratio 10.7 15.0 21.3
2002 shareholders’ equity ($128)
Reduction in equity due to $3,000 dividend
-3,000
Revised shareholders’ equity -3,128
2002 assets $3,328
2002 liabilities 3,455
New debt 3,000
Total liabilities 6,455
Revised liabilities to assets ratio 1.94
2002 EBIT (income before tax + interest
expense)
$895
2002 interest expense 60
Interest on new debt 240
Total interest expense 292
Revised times interest earned ratio 3.07
EBIT can fall 67.4% before interest coverage equals 1.0 ([3.07-1.0]/3.07).
a.WhatwasAvon’sshareholders’equityfrom2001to2003?WhatwereAvon’sliabilities-to-assetsandtimes-interest-earnedratiosintheseyears?(UsePretax
IncomeplusInterestExpenseasEBIT.)WhatdothesefiguressuggestaboutAvon’suseoffinancialleverage?
The first two numbers suggest that Avon is highly levered, so levered that its liabilities exceed the accounting value of its assets in 2001 and 2002. The third
number, on the other hand, shows substantial coverage of interest expense, indicating only modest financial leverage.
c.Assuminga35percentcorporatetaxrate,and2002earningsbeforeinterestandtaxesof$895million,byhowmuchdidAvon’s$60millioninterestexpense
reduce taxes?
Absent interest expense, Avon’s tax bill would be $313.3 million (.35 x $895 million). With the interest expense, the tax bill is $292.3 million (.35 x [$895 million –
$60 million]). This is a reduction of $21.0 million. Alternatively, the interest tax shield is .35 x $60 million = $21.0 million.
d. Answer question (a) and (b) again for 2002 assuming the company had borrowed an additional $3 billion in debt at 8 percent interest at the start of the year and
distributedtheproceedstoshareholdersasaspecialdividend.YoumayignoretheeffectofaddedinterestexpenseonAvon’sbalancesheet.Mightshareholders
benefit from such an increase in financial leverage? Explain
b. What percentage decline in EBIT could Avon have suffered in each year before Avon would have experienced difficulty making its interest payments out of
operating income?
In 2001, EBIT could fall 91% ([10.7-1.0]/10.7). The corresponding percentages for 2002 and 2003 are 93% ([15.0-1.0]/15.0) and 95%, respectively.
(Alternatively, you can use the actual EBIT and interest expense numbers to arrive at the same answer.)
e. HowwouldyouassessAvon’sbusinessrisk?Settingasidethewaythecompanyisfinanced,howsignificantarethemarketplacerisksAvonfaces;how
uncertainarethecompany’sfutureoperatingcashflows?WhatdoesyourassessmentofAvon’sbusinessrisksuggestabouttheleveloffinancialleveragethe
company can prudently support?
Increasing debt by $3 billion increases Avon’s interest expense by $240 million (8% x $3 billion) and its interest tax shield by $84 million a year. This could
increase Avon’s equity by as much as $1 billion. (The present value of $84 million in perpetuity discounted at 8% is $1.05 billion [$84 million/.08]). Remember,
paying a $3 billion dividend will obviously reduce the value of Avon’s equity by $3 billion, but this is precisely offset by the $3 billion cash dividend. Offsetting the
increased tax shield, of course, is the increased distress costs that accompany rising financial leverage. The decision to increase financial leverage must weigh this
cost against the tax benefit. This is the subject of the following questions.
Perusing Avon’s annual report available on www.secinfo.com, it appears the company faces modest business risk. It is a large, geographically diversified company
with over 100 years of operating history, all of which suggests low business risk.
On the other hand, Avon’s sales are highly seasonal, and its products represent discretionary purchases susceptible to the swings in the business cycle. Their
products also appear vulnerable to, often volatile, changes in consumer preferences. These risks are moderated somewhat by the facts that they sell a wide variety of
lower priced items, and they compete in the lower end of the market, both of which should dampen sensitivity to cyclical economic swings and to changes in
consumer preferences.
Avon’s market cap is over $15 billion, while the book value of its assets is under $4 billion, so liquidation would be very costly to creditors and owners. However,
we need to ask whether financial distress would necessarily lead to liquidation. My answer is probably not.
The keys to Avon’s success appear to be creative marketing and a unique, independent sales force. And unless financial distress somehow adversely affected these
strengths, I think bankruptcy — the ultimate financial distress cost — would result in reorganization rather than liquidation. I expect Avon customers would be
largely indifferent to any financial distress because Avon sells small ticket items requiring no service, spare parts, or maintenance. Similarly, there appear to be only
modest switching costs imposed on the new buyer, so there should be little concern that incurring such costs would be in vain in the event of failure. Nor do I see
strong reason to expect the company’s sales force, suppliers, or competitors to significantly change their attitudes toward the company in the presence of financial
distress. Finally, little of the company’s value appears to be in the form of future investment options that might disappear in the event of financial distress.
On balance, it appears that the costs of financial distress to Avon, while not trivial, would be modest compared to many other firms.
g. Based on your analysis and any other considerations you think relevant, is Avon heavily or modestly indebted? Should the company acquire more debt, or shed
existing debt? Why?
As a footnote, during the recent severe recession Avon’s operating income rose 13 percent in 2007, rose 24 percent in 2008, and declined 20 percent in 2009.
Operating income in the first three quarter of 2010 is up modestly from the prior year. This is strong performance in the face of a severe recession and strengthens
the belief that Avon safely could support more debt.
f. How big a threat would it be to Avon if the company took on too much debt and had difficulty servicing it? How costly would financial distress be to Avon?
Explain.
Avon had negative net worth as recently as 2002, suggesting to many an excessive reliance on debt financing. However, it has ample income to shield from taxes,
modest business risk, and at most only moderate costs of financial distress.
In quantitative terms, we observe that at the current capital structure, Avon could suffer declines in operating income of over 90% and still cover interest obligations;
and even with an additional $3 billion of debt, it could still weather declines of over 60%. Comparing these numbers to Avon’s operating stability over at least the
past decade, strongly suggests that Avon can prudently support additional debt – even as much as $3 billion. And a higher debt level might sharpen management
incentives to even better performance. Adding as much as $3 billion in debt would be aggressive but feasible for Avon, and in my judgment it would create value
for owners.
Ultimately, the proof is in the pudding. Past annual reports tell us sales have risen every year for the past 11 years, and operating profits have declined only twice
over the same period, and by less than 1 percent in each instance. This suggests very low business risk, leading to the view that Avon can safely support more debt
Chapter 6 Problem 16 Suggested Answers
Problem 13, part f. in Chapter 3 asked you to construct a five-year financial projection for Aquatic Supplies beginning in 2015.
a. Based on your forecast, or the suggested answer to problem 13(f), calculate the company’s annual times-interest-earned ratio over the forecast period.
b. Calculate the percentage EBIT can fall before interest coverage dips below 1.0 for each year in the forecast.
c. Consulting Table 6-5 in the text what bond rating would Aquatic Supplies have in 2014 if the rating were based solely on the firm’s coverage ratio?
d. Based on this rating, would a significant increase in financial leverage be a prudent strategy for Aquatic Supplies?
Suggested Answers
Actual
a. and b. 2014 2015 2016 2017 2018 2019
EBIT (aka, operating profit) 59.206 48.952 54.826 61.405 68.774 77.027
Interest expense 16.430 18.636 18.801 18.841 18.733 18.446
Times interest earned 3.60 2.63 2.92 3.26 3.67 4.18
% EBIT can fall (answer to b.) 72.2% 61.9% 65.7% 69.3% 72.8% 76.1%
c. According to Table 6-5 in the text, an interest coverage of 3.6 times would earn a weak BBB rating if the rating were based solely on the firm’s coverage ratio..
d. With a coverage ratio of 3.60, significantly increasing financial leverage would be aggressive, putting the company’s debt into the
speculative, or junk, category However, a complete answer to this question requires review of all of the factors described in the Higgins 5 Factors Model.
Suggested Answer to Ch. 3 Problem 13 (f)
2014 Assumptions 2015 2016 2017 2018 2019
Sales 582.762$ 12% 652.693 731.017 818.739 916.987 1,027.026
Cost of Goods Sold 240.828 39% 254.550 285.096 319.308 357.625 400.540
Gross Profit 341.934 398.143 445.920 499.431 559.362 626.486
Aquatic Supplies
Income Statement (in $ millions)
Pro Forma Forecasts 2015 – 2019
Aquatic Supplies
($ millions)
Pro Forma Forecasts 2015 – 2019
Operating Income Before Deprec. 84.427 78.323 87.722 98.249 110.038 123.243
Depreciation, Depletion, & Amortization 25.221 30% 29.371 32.896 36.843 41.264 46.216
Operating Profit 59.206 48.952 54.826 61.405 68.774 77.027
Interest Expense 16.430 initially constant
18.636 18.801 18.841 18.733 18.446
Pretax Income 42.776 30.316 36.025 42.564 50.041 58.581
Total Income Taxes 14.971 35% 10.611 12.609 14.897 17.514 20.503
Net income 27.805$ 19.705$ 23.416$ 27.667$ 32.527$ 38.078$
Balance Sheet (in $ millions)
ASSETS
Cash & Equivalents 7.152$ 2% 13.054 14.620 16.375 18.340 20.541
Account Receivable 70.538 13% 84.850 95.032 106.436 119.208 133.513
Inventories 39.033 5% 32.635 36.551 40.937 45.849 51.351
Prepaid Expenses 9.339 no change 9.339 9.339 9.339 9.339 9.339
Other Current Assets 27.076 6% 39.162 43.861 49.124 55.019 61.622
Total Current Assets 153.138 179.039 199.403 222.211 247.756 276.366
Net Plant, Property & Equipment 81.648 15% 97.904 109.652 122.811 137.548 154.054
Intangibles 9.415 no change 9.415 9.415 9.415 9.415 9.415
Accounts Payable 36.951$ 6% 39.162 43.861 49.124 55.019 61.622
Accrued Expenses 31.206 5% 32.635 36.551 40.937 45.849 51.351
Other Current Liabilities 3.663 no change 3.663 3.663 3.663 3.663 3.663
Total Current Liabilities 71.820 75.459 84.075 93.724 104.532 116.636
Long Term Debt 157.720 initially constant
186.363 188.010 188.414 187.327 184.462
Accrued wages 21.418 3% 19.581 21.930 24.562 27.510 30.811
Total Liabilities 250.958 281.403 294.015 306.701 319.368 331.908