Industrial Products Division Essay
Our valuation estimates accord with the market’s valuation of IPD. A discounted cash flow analysis of the Laboratory Products Division (LPD) and the Environmental Products Division (EPD) suggests a combined value of $9. 69 per share for those two divisions. Based on the current stock price of $22 per share, this suggests that the market values IPD at $187 million. Five-Year Financing Plan Assuming Sale of IPD If the Board accepts the recommendation to sell IPD, we feel the firm will be left with an improved set of options to cover the funding shortfall for supporting its growth objectives.
In our five-year financial projections (see Exhibit 2), after selling the IPD division, we project the company will have sufficient resources for 1990 but will need to raise $164. 1 million in 1991 and an additional $18. 3 million in 1992. Although there are several factors involved, we based our recommendation on the impact to the company’s weighted average cost of capital (WACC) and interest coverage ratio (EBIT to interest expense) of each of these alternatives. We examine the following three options in detail: $100 Million Bank Credit Agreement
We feel the first option-issuing $100 million on a 2-year bank credit agreement-is prohibitive
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In our analysis, this gives the company a WACC of 10. 99% (slightly higher than the current cost of 10.83%), but also lowers the interest coverage to 2. 24 significantly below the 3. 0 desired by the Board. $200 Million in 15-Year Debentures at 11. 25% The second option to raise $200m of 15-year debentures at a coupon rate of 11. 25% is handicapped again because of the same restrictions as in option 1. Because of the 1. 0 total debt to net worth restriction, this again results in the need to raise $100 million in debt along with $100 million in equity. Despite the benefit of longer-term financing for the company compared to option 1, the debt raised also comes with a higher interest rate.
Thus, the higher coupon on the 15-year bonds pushes the cost of debt higher and results in a WACC of 11. 22% with interest coverage even of 2. 21, even lower than in option 1. Recommended Option: Issue $185 million of common stock After reviewing the available options for the company at the current time we believe the company should proceed with Option 3 and raise $185 million of common stock. This option has significant advantages over the other two options. The new equity raised will result in a larger portion of equity financing in the company’s capital structure and less leverage in its operations.
The company’s 50% debt to total value capital structure will decrease to 39% debt to total value. Since a company’s equity beta is impacted by leverage and a higher levered company will have a higher beta of equity, this would result in a reduction in Nova’s new levered beta. After adjusting the company’s capital structure and costs of debt and equity, option 3 will result in a new WACC of 11. 28%.
It is noteworthy that this will leave the company with a slightly higher WACC than in option 1 or option 2, but also leaves the company with an interest coverage of 2.85, significantly higher than the other two options and much closer to the rate desired by the Board. We feel the higher interest coverage keeps the company in a better position for future growth despite the smaller incremental increase to the WACC. Further, an interest coverage ratio closer to 2, as in options 1 and 2, could have serious ramifications such as an inability to service its debt in an economic downturn or a credit rating downgrade that would increase the future cost of debt significantly in the future.
A summary of these options is presented in Table 2. Table 2: Summary of Financing Options, Assuming Sale of IPD Five-Year Financing Plan Assuming Retention of IPD If the Board chooses to retain IPD, Nova will need to raise $153. 4 million, $324. 1 million, $342. 4 million, 340. 3 million and 316. 5 million respectively from 1990 to 1994. As a result, none of the three options considered above can alone meet the peak funding need of $342. 4 million in 1992.
However, if Nova raises funds with new equity, it will have the ability to issue debt as well. To preserve an interest coverage ratio of 3. 0, the maximum amount of debt that Nova can raise at a rate of 11. 50% is $90 million. Thus, in this scenario, we recommend that Nova raises $252. 4 million of equity capital, and simultaneously issues $90 million of 15-year debentures at the 11. 25% rate. This will increase the cost of capital to 11. 47%, although the debt-to-equity ratio will fall to 0. 72, while interest coverage will be maintained at 3. 0.