What is the case for not doing the recapitalization?
The CPK management is known for its conservative financial policy as per its concern for maintaining power. The management should keep in mind the benefits of leverage and tax-shields gains when contrasted with the cost of using all of the borrowing capacity for the future. As CPK has an important growth trajectory, we ought to question whether the growth exceeds the firm’s ability to sustain this growth. To see whether or not this is an issue, we have to analyse the sustainable growth rate through the sources and uses of cash. This method excludes the possibility of new equity financing.
Since the formulas are presented as follows:
Sources of cash = NOPAT + Net new debt
Uses of Cash = change of NWC + change of PPE + Dividends and repurchases + Interest Payments.
We equaled both of the formulas to each other and rearranged the new formula.
We got the equation:
Growth in total capital = ROC + Change in D/TC – Payments/TC
Where the growth in total capital is equal to change in TC/TC, ROC is equal to NOPAT/TC, and payments are equal to dividends plus repurchases plus interest payments.
By using all the debt capacity to repurchase shares, the management restrics the funding of business growth to the level generated by the business operations, ROC. With the ROC for CPK running at 10%, the growth rate should be equal to that, give or take. The growth in new stores was estimated at 16 or 18 on the basis of 213 stores, which represent 7.5% to 8.5% expected growth rate. The 2007 capital expenditure was expected to be $85 million, depreciation was approximately $35 Million based on historical values and the first six months of 2007. A $50 million increase ($85-$35 million) in net property and equipment, NPE, and a book capital base of $226 million represents a 22% growth rate in total capital, not including any increases in new working capital, NWC. The will be adversely affected if the industry’s economics deteriorate further and reduce the company’s ROC.6. What should Collyns recommend?
According to the available financial information, it is most suitable for CPK to finance their debt at 30%. Since CPK did not acquire debt earlier, it is considered risky for them, but the benefits that will arise from it are greater than not having debt at all. Greater returns are forecasted when obtaining debt. Moreover, this time is considered ideal for CPK debt acquirement, as positive prospects are assured from the outperformed benchmarking and the steady growth rate the past 4 years in sales, net operating income and net income. Although we mentioned earlier that there is a slight benefit of repurchasing their stock; as it will raise its value, it is not considered an investment to the firm. In case of a repurchase of stocks, the company will only need to refinance with 20% of the debt, in order to not exceed their credit line of 75 million dollars. The rest of the money could be used in other aspects of the company as to improve and innovate their products.