Capital Structure Changes
Levering Up
With little debt, excess cash, and substantial earnings, Ideko appears to be significantly underleveraged. You plan to greatly increase the firm’s debt and have obtained bank commitments for loans of $100 million should an agreement be reached.
These term loans will have an interest rate of 6.8%, and Ideko will pay interest only during the next five years. The firm will seek additional financing in 20X8 and 20X9 associated with the expansion of its manufacturing plant, as shown in the spreadsheet below. While Ideko’s credit quality should improve over time, the steep slope of the yield curve suggests interest rates may increase; therefore, on balance, you expect Ideko’s borrowing rate to remain at 6.8%.
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Given Ideko’s outstanding debt, its interest expense each year is computed as:
\[\begin{align*} & \text{Interet in Year } t = \text{Interest Rate} * \text{Ending Balance in Year} (t - 1) \end{align*}\]The interest on the debt will provide a valuable tax shield to offset Ideko’s taxable income.
Note:
The above formula assumes that changes in debt occur at the end of the year. If debt changes throughout the year, it is more accurate to compute interest expenses based on the average level of debt during the year.
Info:
A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality but differing maturity dates. The slope of the yield curve gives an idea of future interest rate changes and economic activity.
A normal or up-sloped yield curve is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time, and the fact that investors wish to be compensated more interest when their money is committed to longer-term investments.
A normal curve can steepen (become more upward sloping), when there are increasing expectations of future economic expansion. If investors expect longer-maturity bond yields to become even higher in the future, this would cause some to temporarily park their funds in shorter-term securities, in the hope of purchasing longer-term bonds later for higher yields. This increased temporary demand for shorter-term securities would push up their prices, and lower their yields, causing the yield curve to steepen.
Sources and Uses of Funds for Ideko Acquisition
In addition to the tax benefit, taking out a loan would allow Kleiner Perkins to limit its investment in Ideko and preserve its capital for other investments and acquisitions. The sources and uses of funds for the acquisition are shown below:
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In addition to the $150 million purchase price for Ideko’s equity, $4.5 million will be used to repay Ideko’s existing debt. With $5 million in advisory and other fees associated with the transaction, the acquisition will require $159.5 million in total funds. Kleiner Perkins’ sources of funds include the new loan of $100 million as well as Ideko’s own excess cash (which Kleiner Perkins will have access to). Thus, Kleiner Perkins’ required equity contribution to the transaction would be 159.5 - 100 - 6.5 = $53 million.
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