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Rosario acero, financial analysis

Pablo Este, founder and CEO of Rosario Acero, a small steel mill in Argentina is considering long-term capital for three different reasons.  Este is seeking to raise $7.5 million in capital to restructure their capital.  The company wishes to apply $4.8 Million to pay down the company’s present working-capital line of credit, which is at a 2% premium.  In addition, the company wants to apply $975,000 to repay long-term debt that would mature in mid-1997, figured at 13-15% interest.  Furthermore, the company wants to use $1,725,000 for capital improvements and general purposes.

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Este is considering two options to finance the capital.  The first option includes issuing public stock, which would add approximately 1,000,000 additional stocks at $9.00/share.  This option would cause the senior managers who own 25% of private shares and Mr. Este who owns 51% of private shares to loose control of the company.  The second option would be to issue long-term debt notes with warrants at 13% interest, increasing the financial leverage of the company to close to 60%.  By this maneuvering, the company would loose their financial flexibility to survive a business crisis or event.

Both financing alternatives will affect the performance of the firm in varied manners.  However, the projected profit margins (profit before interest/sales) ratio will continue to remain the same.  The significant distinction will be seen when evaluating the projected profit after interest/sales ratio.  If the company should utilize the debt/warrant financing, profits are decreased due to additional interest costs.

PROFIT MARGIN
1997
1998
1999
2000
2001
2002
EQUITY
4.8%
5.0%
5.2%
5.5%
5.7%
5.9%
DEBT/WARRANTS
3.0%
3.3%
3.6%
3.9%
4.2%
4.5%

The return on equity (profit/equity) indicates the amount of profit a business yields in relation to the money invested.  Utilizing the debt method shows a less performance than the equity method (wikipedia.org).

ROE
1997
1998
1999
2000
2001
2002
EQUITY
14.2%
14.1%
14.0%
13.8%
13.7%
13.5%
DEBT/WARRANTS
24.3%
22.8%
21.6%
20.6%
19.5%
18.6%

Another facet of capital financing to consider when choosing equity versus debt is risk.  Principal risks can vary depending on external and internal risks adherent to each specific industry.  Rosaria Acero faces wide-ranging principal risks.  Market fluctuation risk is a significant consideration with the Argentina stock market so closely tied with various other South American markets.  The Mexican peso crash of 1994 had dampened the Argentina’s market, but as of 1997, Argentina’s market had rebounded especially in the older, stable industries.  Foreign exchange risk is another consideration since Argentina became part of the Mercosur trade group, promoting trade with Brazil and Uruguay.  Interest rate risk is another significant consideration, although with the forecasted low inflation between 2.5% and 4%, and real gross national product growth at 1.5% to 6%, this risk does not seem like a large factor.  Product distinction risk is a small consideration, but one none the less to consider due to the product specialization of this small steel mill.  Employee dissatisfaction is another risk, due to the union contracts.  Bond rating risk will be a major risk, if they choose the debt with warrant type financing.  If the company shows bad performance, interest rates on the long-term bonds could increase.  Anything higher than the 13% per annum, would critically strain Rosario Acero’s profit margins.

If Rosario Acero did decide to issue the debt/ warrant option, they could continue to service the debt under a reasonable downside scenario, but profit margins would become very strained.  Rosario Acero would not have the financial flexibility to rebound quickly if they chose the debt with warrant type of financing.

If Rosario Acero chose the debt with warrant option financing, the notes and warrants package would be very attractive to investors from Rosario’s standpoint.  Rosario Acero S.A would be offering a 5.5% premium over the 8.5% lending base rate at 13% interest.  Senior subordinated notes without warrants for Turismo S. A., a competitor in the steel industry with a bond rating of CCC+, were offered at 13.250 with a maturity date of 2003.

If Rosario Acero chose the equity financing, an offering price of $9.00 per share by Rosario Acero S.A would be fair and reasonable to new investors.  Senior managers had paid $9.00/share 12/1996 for an additional 28,550 shares.  Presently, Argentina’s market value of shares for the heavier industries is more stable than mass communications and communication issues.  Senior managers may have some concerns about the initial dilution of their original shares, but if they held them for several years, then they most likely would see a strong return.

Este should adopt the equity option to raise growth capital instead of debt/warrant financing.  This decision is based on maximizing the value of the firm and minimizing the firms weighted average of the cost of capital.  The company will continue to utilize the $5 million open line of credit with a 2% premium, but the mix with more equity financing will allow the financial flexibility a young company needs to survive turbulent periods.

Initially, present stockowners may see a decrease in the book value of their shares and may be anxious with agreeing to equity financing.  For equity financing of the $7.5 million in cash, 1,000,000 additional shares would be issued to the already 200,000 shares presently outstanding.  The book value of the shares before dilution is estimated to be $15.43/share.  However, with the addition of the public shares, the book value would be reduced to $4.20/share immediately.  $4.20/share is approximately half of the $9.00/share asking market price for the new stock.  In addition, if glancing at the projected earnings per share only, earnings per share appears to be weaker with the equity based financing than the debt with warrants.  See Table.

EARNINGS PER SHARE
1997
1998
1999
2000
2001
2002
EQUITY
$1.72
1.99
2.29
2.64
3.02
3.45
DEBT/WARRANTS
$4.96
6.04
7.29
8.70
10.28
12.06

However, the projected retained earnings are higher with the equity financing versus the debt with warrant financing.  See following table.

RETAINED EARNINGS(Millions)
1997
1998
1999
2000
2001
2002
EQUITY
5.03
7.15
9.59
12.41
15.63
19.30
DEBT/WARRARRANTS
4.35
5.76
7.46
9.49
11.88
14.69

By observing the projected retained earnings, the maximum value of the firm is shown.   The projected book values with equity financing are $10.77/share for 1997, $12.54/share for 1998, $14.57/share for 1999, $16.92/share for 2000, $19.60/share for 2001, and $22.66/share for 2002.  By 2002, book value of the shares would be up to $22.66/share, but with the increase in the value of the firm, market value could excel much higher.  The present stockholders would be able to cash in well on their original shares that were purchased at $3.00/share (Curtice).

In addition, by issuing equity financing, the company would be in a better position to ride out any significant crisis occurring.  If the company would take out the debt with warrants, the company would be highly leveraged.  When a company is highly leveraged, any serious business calamities will be enlarged and more difficult to control.

A disadvantage to increasing the amount of shares would be the fact of losing majority control of the company.  At present the senior management control 25% and Estes owns 51%.  However, this could be reflected in a more positive light if Estes is serious about retiring later, since he is now 66y/o.  He could hold on to his shares for several more years and then as they increased with value, begin to sell them off in increments.

Present timing is ideal for the decision to issue equity capital due to a recent upturn in the Argentina markets.  The market shows a strong demand in the steel sector in Argentina.  Buyers from outside of Argentina are increasing their orders from Argentina, showing good future growth for the steel industry.  Furthermore, Argentina’s overall economic growth is currently more promising, giving investors’ confidence in the stock markets (Bruner, Robert F.) .

WORKS CITED

Curtice, Robert M. Stakeholder Analysis: The Key to Balanced Performance Measures http://www.bptrends.com/publicationfiles/04-06-WP-StakeholderAnalysis-Curtice.pdf.  Accessed 12/02/2006.

Bruner, Robert F.  Structuring Corporate Financial Policy: Diagnosis of Problems and Evaluation of Strategies (v. 1.5) University of Virginia – Darden Graduate School of Business Administration.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=909358.   Accessed 12/02/2006.

http://en.wikipedia.org/wiki/Financial_measures#Performance.  Accessed 12/02/2006.

 

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