Sealed Air Co. Case Study queestions. Why did Sealed Air undertake a leveraged recapitalization? Do you think that it was a good idea? For whom?

University Degree Business and Administrative studies

1.Question One & Answer

Why did Sealed Air undertake a leveraged recapitalization? Do you think that it was a good idea? For whom?

Sealed Air had traditionally neglected manufacturing in favor of marketing, they were able to do this because of a lack of competition, however mid-1980s increased competition and expiring patents on products, Sealed Air reacted to this increasing competition by introducing the WCM-World Class Manufacturing program which promoted manufacturing excellence. This increased Sealed Air’s cash and debt capacity.

1989-stock price seemed to be undervalued, it was depressed and did not seem to be improving in the near future. Sealed Air had a problem with managing their cash, Sealed Air had 50 million in cash and short term investments and the cash on hand as stated in the case was expected to double in the next year.

Reasons for Sealed Air undertake a leveraged recapitalization because it had a lot of free cash flow which tempted the company to waste money. Excess free cash flow arises when the company has more free cash in excess of that needed to fund the investments. Meanwhile, Seal Air did not have good investments and M&A opportunities.

Competitors were marketing cheap imitations of Sealed Air’s products by inventing around Sealed Air’s manufacturing process patents. From Managers’ point of view, Sealed Air’s leverage recapitalization was a good idea in the context of its changing competitive environment as the company had reached a stage in the mid-1980s where competition was increasing as other competitors started to produce the products that were previously patented by the company such as the air cellular patent which had expired. Competitors were selling them for a cheaper price. The company specifically face increasing competition in Europe as prior to the mid-1980s Sealed Air was unable to secure a strong position with patents and distributors that would allow them to take advantage of their innovative products for a much longer period of time. From employees’ point of view, although in a short term it cut the expense for them, employee stock ownership was good in a long term. For investors and debt holders, it depends on the sensitive of risk. It seemed it was not good for them if they were risk averse, vice versa.

2. Question Two and Answer

How much value was created? Where did it come from?

Sealed Air, with 8.245 million shares of common stock outstanding, paid a one-time special cash dividend of $40 per share on May 11, 1989.

The Exhibit above shows that on the Ex-Dividend Date, the market value of Sealed Air’s equity increased 54.7 million from the day before announcement of recap. At the end of 1989, the value had increased 119.6 million.

We use adjusted present value method to calculate how much value was created.

VL = VO + TC D – f(D)= VO + TC D - (probability of bankruptcy* cost of bankruptcy)

= VO + TC D - (probability of ...

This is a preview of the whole essay

Sealed Air, with 8.245 million shares of common stock outstanding, paid a one-time special cash dividend of $40 per share on May 11, 1989.

We use adjusted present value method to calculate how much value was created.

VL = VO + TC D – f(D)= VO + TC D - (probability of bankruptcy* cost of bankruptcy)

= VO + TC D - (probability of bankruptcy*π* VO)

VL1 = Market Value of Equity + Book Value of Debt = 8.245*45.875+ 35.5 = 378.24+35.5= 413.74

VL1 = VO + TC D1 – f(D)1 VO = VL1 -TC D + f(D) = 413.74 – 35.5*35% = 401.32

We ignore the f(D)1 because the amount of debt before recapitalization is so small that the probability of bankruptcy and the cost of bankruptcy are small as well.

EBIT Interest coverage ratio = 53.7/17.1 = 3.14 (Rate BB)

EBITDA interest coverage ratio = 69.9/17.1 = 4.08 (Rate BBB)

Long-term debt/cap = 65% (Rate B)

Sealed Air rate at B+

Cash used to pay dividend is 21.3 million

VL2= VO + TC D2 – f(D) 2= 401.325 – 21.3 + 35%*311.1 –19.28%*20%*378.24

= 380+108.885 – 14.585= 474.3

VL2 - VL1=474.3–413.74 = 60.56

Therefore, 60.56 million was created by the tax shield with increasing debt ratio. In addition, this result is close to the market response 54.7 million.

3. Question Three and Answer

Is pursuing a program of manufacturing excellence such as World Class Manufacturing (WCM) inconsistent with “levering up”?

No. After the implementation of WCM, Sealed Air had more in cash and effectively motives the employee. The main lesson of WCM is that if you do it right you can have it all- high quality, low cost, fast and dependable customer service and reduced working capital. Sealed Air at all levels and at all locations is dedicated to achieving WCM through total quality (TQC), just-in-time inventory(JIT), total material usage(TMU), total preventative maintenance(TPM) and employee involvement(EI). WCM will automatically stimulate innovation throughout the company, which will help to produce a steady flow of new products and new ways of operating our business and serving the customers.

4. Question Four and Answer

Why did Dermot Dunphy, the CEO, feel it was necessary to change the company’s priorities and incentive structure following the recap?

In the case of Sealed Air's leveraged recapitalization, the management had purposefully and successfully used the leveraged recapitalization as a watershed event. The main reason of creating such a crisis was to disrupt the status quo and to promote internal changes in the company. Thus after recapitalization the most important thing was the need to reestablish whole new objectives, change the compensation systems, and reorganizing manufacturing and capital budgeting processes so as to realign the organizational behavior of the company to meet the leverage’s desired disciplinary effect.

A key indicator of whether leverage is having the desired disciplinary effects is the post-recap balance sheet progress. The large overhang of debt service obligations galvanizes management to improve operational performance thus generating sufficient cash flows to pay down the debt. Thus the management’s priority was to put the their customers first and a their cash flow objective was redefined in such a manner that it took care simultaneously to increase sales and margins, have less inventory, less capital expenditure and faster collection.

With the objectives clearly spelt out, the new bonus plan and new employee stock ownership was introduced so as to serve as an act of extrinsic motivation for the employees to work towards their objectives.

5. Question Five and Answer

Why did Sealed Air’s investor base turnover completely after the recap? Is this something managers should be concerned about?

(1) After the new dividend payout policy was implemented, Sealed Air would have a debt-to-book value ratio of 1.36 and negative net worth of $160.5 million, while the future cash flow is uncertain, this change will drastically heighten the financial leverage ratio as well as the risk faced by investors.

So, under the circumstances, conservative investors who are more risk averse tend to sell the stock to the recap because they prefer to invest in companies with stable return, growth and limited risk. But speculative investors who are more risk preferred tend to hold the stock because they are willing to look beyond the negative equity and cash flow projections from which they may look for significant gains in profitability. So Sealed Air’s investor base turnover completely after the recap

(2)Managers totally should be concerned about this. Because the speculative investors hold the company’s stocks chasing for significant gains in profitability, they care only about the short term profit which will leads to the price fluctuation and further increase the risk face by the company.

6. Question Six and Answer

Was the constraint imposed on capital expenditures under the bank lending agreement good or bad for the company? Do you think managers will be able to successfully renegotiate this covenant?

Part of the debt covenants with the banks, Sealed Air agreed to the scheduled capital expenditures obligations.

From Sealed Air Corporation’s point of view, the loan constraint is contractual restrictions placed on a borrower. There are two broad classifications of covenants: affirmative and negative. On one hand, the restrictions o the company’s expenditures give the management and employees the pressure by cutting its budget and restructure their formal capital budgeting process. The constraint has forced the employee to prioritize the capital expenditures and which could subsequently improve its performance.

On the other hand, the constraint somehow may be a stumbling block of the company’s future growth. For example, the company can only spend $7 million in 1991, which is the amount of the expenditure spend on in Europe. The company’s management considered this number to be too low to boost the sales growth and capacity of multiple plants.

The banks stated that they won’t lend Sealed Air Corporation without track record for managing the large amounts of loan. From the debt holder’s point of view, setting minimum standards for a borrower’s future conduct and performance could help the bank managing the credit risk. It’s an important part of banks’ risk management strategies. The recapitalization and high leverage and negative net worth substantially increase the downside risk and the probability of default. Somehow, the constraints of the loan agreement shift the debt holder’s position to share holder’s position. The banks need to track the company’s performance to control the risk of their loans.

Besides, the restriction on the expenditure also can increase the net profit and make the use of leverage more efficient. The restrictions typically also accelerate the maturity of the loan in the event of a violation. So the managers will not be able to successfully renegotiate this covenant.

7. Question Seven and Answer

Would such an increase in leverage be good for all companies? Why or why not?

Sealed Air Corporation’s leveraged Recapitalization is a strategy where a company takes on significant additional debt with the purpose of paying a large dividend. The result is a far more financially leveraged debt ratio which is called "optimal" debt capacity. This technique can be used, and has been used, as a "shark repellant" to ward off a hostile takeover. This is done by adding debt, eliminating idle cash and debt capacity. M&M showed that the value of a firm is independent of the ratio of debt to equity used by the firm in financing its investments.

This strategy refers to the trade-off theory: a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. However, an increase in leverage is not good for all companies.

Different companies have different optimal debt levels based on different industry, different market, and different developing stages. For example, in the Pfizer case, part of these knowledge-based companies’ market value comes from their potential future growth. Companies need to maintain a low debt level and prepare more cash to decrease the cost of bankruptcy. The financial industry such as bank, money is their commodity. The profitability comes from their high leverage. These two different types of operating business industry obviously will have different optimal debt level and it’s not comparable.

Different developing stages will also have different optimal leverages. For example, the young firms in high-growth industries tend to use less debt, which have high future volatility. However, firms in stable industries with large quantities of fixed assets tend to use more debt, which need more capital investment in the future growth and development.