Competitive risks - Competitive risk refers to whether the present competition will retaliate against any moves being made or contemplated by the company and, equally important, the likely intensity of this retaliation.
Managerial risks - Managerial risk has two components. First, one must consider whether management has the skills, capability, and longevity to exe-cute a particular strategy and the second aspect of managerial risk relates to management’s enthusiasm for a particular strategy, given the values of the top management team. Sometimes an "ideal" strategy can be worked out on paper but, for whatever reason, does not conform to the true predilections of top management and will not be carried out with as much energy as might otherwise be the case.
- polaroid’s peer firms are
- Fuji, a leading competitor based in Japan, has a strong market share in the instant photography industry.
- Sony
- Kodak
Criteria used
- Same industry’s instant photography (Fuji) and digital industry (Sony, Kodak)
- Similar products
3
- debt polaroid could borrow at each rating level
Using total debt /total capital the amount of debt for each rating are:
AAA – 374.13 million
AA – 485.35 million
A – 573.47 million
BBB – 690.47 million
BB – 858.03 million
B – 1003.93 million
- EBIT coverage ratios
EBIT coverage ratio relates the company’s earnings before interest and taxes to its interest expense. The lower the interest coverage ratio, the higher will be the company's debt burden and the greater the possibility of bankruptcy or default. That is why this ratio should increase when moving from junk B rated companies to AAA rated companies. Having an EBIT of 89.2 in1995, Polaroid’s EBIT coverage ratio is 1.71. Using exhibit 11, one may compute the EBIT coverage ratios for each rating category. The EBIT coverage ratio for Polaroid in each credit rating category is very sensitive to the future earnings before interest and taxes the enterprise will generate and to the evolution of the cost of debt for each category. Taking into account the interest coverage ratio is important because it can give a clear picture of the short-term financial health of the business. As it can be seen above, Polaroid will not only need to lower its debt but also will need to generate a higher EBIT in order to qualify for a better rating
4
- which rating category has the lowest overall cost of funds
The Hudson Guaranty estimates of capital costs in Exhibit 11 and the financial ratios in Exhibit 9 indicate that the lowest industry WACC is enjoyed by firms with BBB-rated bonds. It is at this point that you take on more debt while ensuring flexibility.
- Do you agree with Hudson Guaranty’s view that equity investors are indifferent to the increases in financial risk across that investment grade debt category?
Yes
Within the investment grade debt category, investors are indifferent to the increases in financial risk because within this grade the perceived risks of bankruptcy are still minimal. Although the more the debt a company takes on, the higher the risk of the company because of its obligation to pay off its debtors before its shareholders it is expected that shareholders will demand a return that is adequate to the new risk. But applying Hudson’s view, within the investment grade category the cost of debt and equity are increasing as the bond rating drops from AAA, the WACC is reducing. From this we can see that management is creating more value for its shareholders while maintaining flexibility and it is still within an investment grade credit rating.
5
Yes,
All of the firm's debt was due within six years. Consequently all the company's borrowing would need to be repaid or refinanced in a relatively short amount of time. Currently, Polaroid had a Standard and Poor's rating of BBB, the lowest rating of investment-grade debt. Norwood needed to maintain the company's investment-grade rating due to the higher cost of issuing non-investment-grade debt. Moreover, a lower bond rating could have negative repercussions of Polaroid brand equity.
6
Ralph Norwood’s recommendations
- They target bond rating – Polaroid should maintain a target bond rating of BBB, because it is at this point that they achieve the lowest possible WACC in the industry while remaining flexible.
- the level of flexibility or reserves – Since even maintaining the current debt levels does not cause Polaroid to fall below a BBB rating if it earns its projected income, it might be unnecessarily conservative to go to too low a debt level and lose the benefits of leverage. A partial pay down on the long-term debt with equity followed by a rollover of remaining debt in future years is a viable option that preserves the benefits of debt and still allows Polaroid substantial flexibility.
- The mix of debt and equity – 47.8% debt and 52.2% equity as shown in question 4 above. The reasoning for this distribution of Polaroid's weights of debt and equity is the current mix seems to be right on as proven by their lowest possible WACC at BBB rating. Polaroid has also forecasted increases in sales and operating profit. Even though Polaroid is optimistic in future years it is important to use any gains from these future cash flows as cushion against industry risk so Polaroid will have lower risk of falling below BBB rating.
- The maturity structure of debt – because of the nature of its industry which requires a lot of investment in R&D, Polaroid needs to seek more long term financing and now is the best time to raise equity because its stocks seems to be overvalued because of their stock repurchase strategy. And if Polaroid needs to take on more debt it should acquire debts with longer maturity structure with a callable option should in case the market changes significantly.
