The Armstrong Production Company is an industry-leading firm in the field of manufacturing synthetic building materials for homes and commercial structures, based near St. Louis. Armstrong was fortunate in its initial stages to quickly secure inexpensive funding in the form of developmental loans issued by the State of Illinois, and thus was able to break even within three years of its founding in the early 1970s. Able to pour resources into its research and development segment, riding on the increasing demand for construction materials from the 1970s to 1980s, and issuing 15 million shares for the company in an initial public offering (20% of this is currently owned by the board of directors, with another 13% controlled through the company’s employee stock ownership plan). Armstrong Production was able to greatly expand without incurring an overwhelming amount of debt. Following the stock issue, debt composed only 10% of the firm’s capital structure, with equity (that is, money earned from issuing stocks and retaining earnings in the company) composing the rest. Wanting to diversify into consumer goods and furniture, as well as providing disincentive to opportunistic acquirers of companies with low debt, Armstrong’s board decided was persuaded to issue $145 million in bonds in the mid-1980s, after some hesitation concerning interest rates. The further expansion of the company proved a fiscally-sound decision, resulting in record annual earnings of $115 million in 1990. However, the next year, the construction boom of the last two decades came to an end and the construction materials industry contracted considerably, resulting in downsizing in many firms. Thanks to its push to diversify its products a few years earlier, Armstrong was able to weather the downturn relatively well, with earnings before taxes or interest stabilizing at about $85 million in 1996.
Currently, the company’s debt is $110 million, composing approximately 25% of the firm’s capital structure. Several of Armstrong’s board members are concerned about the possibility of the firm going into bankruptcy and have discussed with Armstrong’s chief financial officer about lowering this debt level. Uncertain of future macroeconomic performance, the planning committee has developed the following three scenarios and their effect on the company’s earnings before interest and taxes (EBIT)… Probability
The company’s stock currently trades at $22.00 a share. While some within the Armstrong’s upper management want to use the company’s good reputation to issue more shares and reduce its debts, others want the company to buy back existing shares, though this would further increase the company’s debt. In any case, the company would be forced to refund all existing bondholders at par value if the company’s capital structure were modified by the exchange of debt and equity. Though the company may buy back shares, it has no plans to undertake new project requiring external funding, though some within the company (including its marketing vice president and second-largest shareholder) believe that such a cautionary stance is bad for business and that the company should either expand internally or should acquire subsidiaries, even if it means taking on further debt in order to do so. There are no specific suggestions as to what the nature of this expansion should be.
Our team has been asked by Armstrong’s chief financial officer to analyze the company’s capital structure in time for the next annual board of directors meeting, and to educate those in attendance about capital structuring through hypothetical examples. Specifically, we are to discuss…
1. …The different types of risk and how risk is measured… 2. …How debt affects risk and return to the company… 3. …The differences between on company financed with $400 million of equity, and one with $200 million...
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