Weekly Challenge 3

            Spinnet Telecommunications reported earnings before interest and taxes of $ 50 million on a book value of capital of $ 500 million in the most recent financial year (which I will refer to as the current year. The book value of equity was $ 400 million and the book value of debt was $ 100 million. The debt is in the form of 10-year bank loans (balloon payment all the principal is due at the end of the 10th year) and the interest expense in the current year was $8 million. In the course of your analysis, you uncover the following:

a. The firm has operating lease commitments for the next few years and they are summarized below:

Year

Lease Commitment

Current year

$ 22 million

1

$ 24 million

2

$ 22 million

3

$ 22 million

4

$ 21 million

5

$ 20 million

Beyond yr 5

$ 111 million

b. The firm is not rated, but you believe that it would be rated using criteria based upon smaller and riskier firms. The table summarizing interest coverage ratios and ratings for such companies is provided below.

Interest coverage ratio > ≤ to Rating is Spread is
-100000
0.499999
D
12.00%
0.5
0.799999
C
10.50%
0.8
1.249999
CC
9.50%
1.25
1.499999
CCC
8.75%
1.5
1.999999
B-
6.75%
2
2.499999
B
6.00%
2.5
2.999999
B+
5.50%
3
3.499999
BB
4.75%
3.5
3.9999999
BB+
3.75%
4
4.499999
BBB
2.50%
4.5
5.999999
A-
1.65%
6
7.499999
A
1.40%
7.5
9.499999
A+
1.30%
9.5
12.499999
AA
1.15%
12.5
100000
AAA
0.65%

c. The firm reported $ 45 million in R& D expenses in the current year. Based upon your belief that there is a 3-year amortizable life for research, you collected R&D expenses for the last 3 years:

Year     R&D expense

-1         $ 35 million

-2         $ 25 million

-3         $ 15 million

d. The unlevered beta for other telecommunications firms is 1.25 (You can assume that this unlevered beta was computed using all of the debt including operating lease commitments- for the other firms in the sector)

e. The firm has 50 million shares outstanding, trading at $ 5 per share.

f. The 10-year treasury bond rate is 2% and the market risk premium is 6%. The marginal tax rate is 40%.

Questions

1. Estimate the synthetic rating for the firm and the appropriate pre-tax cost of debt.

2. Estimate the market value of interest bearing debt at the firm.

3. Estimate the debt value of operating leases

4. Estimate the value of the research asset

5. Estimate the operating income with the operating lease and R&D adjustments (before taxes)

6. Estimate the operating income with the operating lease and R&D adjustments (after taxes)

7. Estimate the book values of equity and debt with the operating lease and R&D adjustments

8. Estimate the adjusted after-tax return on capital for this firm and contrast to the unadjusted number.

9. Estimate the cost of equity for the firm.

10. Estimate the cost of capital for the firm.