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Capital Structure - Financial Statement Analysis - Lecture Notes, Study notes of Financial Statement Analysis

Amity University - BiharFinancial Statement Analysis

Capital Structure, Relative Amounts, Equity Financing, Credit Risk, Bankruptcy Risk, Becoming Insolvent, Significantly, Relatively High Capital, Stable Cash Flows, Relatively Predictable are some points of this lecture handout of Financial Statement Analysis course.

Typology: Study notes

2011/2012

Uploaded on 12/13/2012

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Financial Analysis Chapter 9 Page 1 of 10
Financial Analysis: A User Approach
Chapter 11
Capital Structure and Credit Risk
Capital Structure refers to the relative amounts of debt vs.
equity financing. It also refers to the relative amounts of short-
term vs. long-term borrowing.
Credit Risk includes both default risk (a borrower failing to
make a payment on time) and bankruptcy risk (a borrower
becoming insolvent)
Capital Structures vary significantly between industries –
Companies with relatively high capital needs combined with
relatively predictable and stable cash flows are good candidates
for taking on significant debt. On the other hand, if a company
has only limited capital needs and/or has highly variable cash
flows they would not be a good candidate for significant
amount of borrowing, especially long-term borrowing.
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Download Capital Structure - Financial Statement Analysis - Lecture Notes and more Study notes Financial Statement Analysis in PDF only on Docsity!

Financial Analysis Chapter 9 Page 1 of 10

Financial Analysis: A User Approach

Chapter 11

Capital Structure and Credit Risk

Capital Structure refers to the relative amounts of debt vs.

equity financing. It also refers to the relative amounts of short-

term vs. long-term borrowing.

Credit Risk includes both default risk (a borrower failing to

make a payment on time) and bankruptcy risk (a borrower

becoming insolvent)

Capital Structures vary significantly between industries –

Companies with relatively high capital needs combined with

relatively predictable and stable cash flows are good candidates

for taking on significant debt. On the other hand, if a company

has only limited capital needs and/or has highly variable cash

flows they would not be a good candidate for significant

amount of borrowing, especially long-term borrowing.

Financial Analysis Chapter 9 Page 2 of 10

Consider the following:

Company DUK TGT STX AAPL MSFT

Current Assets 10% 40% 54% 82% 57%

Non-Current Assets 90% 60% 46% 18% 43%

Total Assets 100% 100% 100% 100% 100%

Current Liabilities 8% 24% 43% 34% 36%

Long-Term Liabilities 52% 45% 31% 12% 12%

Total Liabilities 60% 69% 74% 46% 48%

Total Stockholders’ Equity 40% 31% 26% 54% 52%

Total Liab. & Stockholders’ Equity 100% 100% 100% 100% 100%

Even within the same industry, some companies will pursue

different capital structures. Consider the following:

Company STX WDC MSFT

Current Assets 54% 58% 45%

Non-Current Assets 46% 42% 55%

Total Assets 100% 100% 100%

Current Liabilities 43% 30% 22%

Long-Term Liabilities 31% 12% 24%

Total Liabilities 74% 41% 46%

Total Stockholders’ Equity 26% 59% 54%

Total Liab. & Stockholders’ Equity 100% 100% 100%

Financial Analysis Chapter 9 Page 4 of 10

Long-Term Debt and Credit Facilities The carrying amount of long-term debt consisted of the following:

June 27, 2008

June 29, 2007 Floating Rate Senior Notes due October 2009 $ 300^ (In millions) $ 300 6.375% 6.8% Senior Notes due October 2016 Senior Notes due October 2011 599599 599598 6.8% 5.75% Convertible Senior Notes due April 2010 Subordinated Debentures due March 2012 (^13541 ) 2.375% LIBOR Based China Manufacturing Facility Loans Convertible Senior Notes due August 2012 32630 32660 2,030 2, Less current portion (360) (330) Long-term debt, less current portion $ 1,670 $ 1,

In September 2006, Seagate Technology HDD Holdings (“HDD”), the Company’s wholly-owned direct subsidiary,

issued senior notes totaling $1.5 billion comprised of $300 million aggregate principal amount of Floating Rate

Senior Notes due October 2009 (the “2009 Notes”), $600 million aggregate principal amount of 6.375% Senior

Notes due October 2011 (the “2011 Notes”) and $600 million aggregate principal amount of 6.8% Senior Notes due

October 2016 (the “2016 Notes”). These notes are unsecured and rank equally in right of payment with all of

HDD’s other existing and future senior unsecured indebtedness and senior to any present and future subordinated

indebtedness of HDD.

$300 Million Aggregate Principal Amount of Floating Rate Senior Notes due October 2009. The 2009 Notes bear

interest at a floating rate equal to three-month LIBOR plus 0.84% per year, payable quarterly on January 1, April 1,

July 1 and October 1 of each year. Interest payments commenced on January 1, 2007. The 2009 Notes will mature

on October 1, 2009. The Company may not redeem the 2009 Notes prior to maturity.

$600 Million Aggregate Principal Amount of Fixed Rate Senior Notes due October 2011. The 2011 Notes bear

interest at the rate of 6.375% per year, payable semi-annually on April 1 and October 1 of each year. The 2011

Notes are redeemable at the option of the Company in whole or in part, on not less than 30 nor more than

60 days’ notice at a “make-whole” premium redemption price. The “make-whole” redemption price will be equal

to the greater of (1) 100% of the principal amount of the notes being redeemed, or (2) the sum of the present

values of the remaining scheduled payments of principal and interest on the 2011 Notes being redeemed,

discounted at the redemption date on a semi-annual basis at a rate equal to the sum of the applicable Treasury

rate plus 50 basis points.

$600 Million Aggregate Principal Amount of Fixed Rate Senior Notes due October 2016. The 2016 Notes bear

interest at the rate of 6.8% per year, payable semi-annually on April 1 and October 1 of each year. The 2016 Notes

are redeemable at the option of the Company in whole or in part, on not less than 30 nor more than 60 days’

notice at a “make-whole” premium redemption price. The “make-whole” redemption price will be equal to the

greater of (1) 100% of the principal amount of the notes being redeemed, or (2) the sum of the present values of

the remaining scheduled payments of principal and interest on the 2016 Notes being redeemed, discounted at the

redemption date on a semi-annual basis at a rate equal to the sum of the applicable Treasury rate plus 50 basis

points.

Financial Analysis Chapter 9 Page 5 of 10

$135 Million Aggregate Principal Amount of 6.8% Convertible Senior Notes due April 2010 (the “6.8% Notes”). As a

result of its acquisition of Maxtor on May 19, 2006 (see Note 10), the Company assumed the 6.8% Notes. The

6.8% Notes require semi-annual interest payments payable on April 30 and October 30. The 6.8% Notes are

convertible into common shares of Seagate Technology at a conversion rate of approximately 30.1733 shares per

$1,000 principal amount of the notes. Commencing May 5, 2008, the Company may redeem the 6.8% Notes at

100% of their principal amount, plus accrued and unpaid interest, if the closing price of the common shares for 20

trading days within a period of 30 consecutive trading days ending on the trading day before the date of the

mailing of the redemption notice exceeds 130% of the conversion price on such trading day. If, at any time,

substantially all of the common shares are exchanged or acquired for consideration that does not consist entirely

of common shares that are listed on a United States national securities exchange or approved for quotation on the

NASDAQ National Market or similar system, the holders of the notes have the right to require the Company to

repurchase all or any portion of the notes at their face value plus accrued interest.

$326 Million Aggregate Principal Amount of 2.375% Convertible Senior Notes due August 2012 (the

“2.375% Notes”). As a result of its acquisition of Maxtor on May 19, 2006 (see Note 10), the Company assumed the

2.375% Notes. The 2.375% Notes require semi-annual interest payments payable on February 15 and August 15.

The 2.375% Notes are convertible into common shares of Seagate Technology at a conversion rate of

approximately 58.6938 shares per $1,000 principal amount of the notes, at the option of the holders, at any time

during a fiscal quarter if, during the last 30 trading days of the immediately preceding fiscal quarter the common

shares trade at a price in excess of 110% of the conversion price for 20 consecutive trading days. Upon conversion,

the 2.375% Notes are subject to “net cash” settlement whereby the Company will deliver cash for the lesser of the

principal amount of the notes being converted or the “conversion value” of the notes which is calculated by

multiplying the conversion rate then in effect by the market price of the Company’s common shares at the time of

conversion. To the extent that the conversion value exceeds the principal amount of the 2.375% Notes, the

Company will, at its election, pay cash or issue common shares with a value equal to the value of such excess. If the

2.375% Notes are surrendered for conversion, the Company may direct the conversion agent to surrender those

notes to a financial institution selected by the Company for exchange, in lieu of conversion, into a number of the

Company’s common shares equal to the applicable conversion rate, plus cash for any fractional shares, or cash or a

combination of cash and the Company’s common shares in lieu thereof. The 2.375% Notes are classified as a

current liability on the consolidated balance sheets because they are currently convertible as the Company’s share

price was in excess of 110% of the conversion price for at least 20 consecutive trading days during the last 30

trading days of the fourth quarter of fiscal year 2008. The payment of dividends to holders of the Company’s

common shares have in certain quarters resulted in upward adjustments to the conversion rate of the

2.375% Notes and may continue in the future. If the conversion rate continues to increase, the Company may be

required to book an increased amount of interest expense.

$55 Million Aggregate Principal Amount of 5.75% Subordinated Debentures due March 2012 (the

“5.75% Debentures”). As a result of the Maxtor acquisition (see Note 10), the Company assumed the

5.75% Debentures. The 5.75% Debentures require semi-annual interest payments on March 1 and September 1

and annual sinking fund payments of $5 million or repurchases of $5 million in principal amount of debentures in

lieu of sinking fund payments. The 5.75% Debentures are currently convertible for a cash payment of $167.50 per

$1,000 principal amount of debentures.

$60 million LIBOR Based China Manufacturing Facility Loan. As a result of the Maxtor acquisition (see Note 10), the

Company assumed an outstanding plant construction loan in the amount of $30 million and an outstanding project

loan in the amount of $30 million. In fiscal year 2008, the Company repaid the $30 million project loan. The

Financial Analysis Chapter 9 Page 7 of 10

Ratio Analysis to Identify Default and Bankruptcy Risk

Ratios we previously used that can be useful:

Debt/Equity

Long-Term Debt to Equity

Interest Coverage (Times Interest Earned)

Two additional ratios:

Financial Leverage Index (FLI) = ROE^ =

Net Income/Average SHE

ROA Net Income/Average Total Assets

Financial Structure Leverage Index (FSLR) = AverageAverage Total Assets Stockholders’ Equity

For Seagate:

FLI 2.10 1.

FSLR 2.10 1.

Financial Analysis Chapter 9 Page 8 of 10

Altman’s Z-Score

A generalized model to predict bankruptcy

Z = 6.56 X (Working Capital/Total Assets)

+ 3.26 X (Retained Earnings/Total Assets)

+ 6.72 X (EBIT/Total Assets)

+ 1.05 X (Book Value of Equity/Book Value of Debt)

Generally the lower your Z-Score the more likely you are to go

bankrupt.

Range Interpretation

< 1.1 Bankrupt

1.1 to 2.6 Gray Area

> 2.6 Healthy

Financial Analysis Chapter 9 Page 10 of 10

Bond Ratings

Several companies provide a rating for company debt. The

rating should help an investor to understand the riskiness of

the borrower/borrowing.

Standard

& Poors Moody’s Category

Highest Rating AAA Aaa Investment Grade

Very High Quality AA Aa Investment Grade

High Quality A A Investment Grade

High Quality BBB Baa Investment Grade

Speculative BB Ba Below Investment Grade

Speculative B B Below Investment Grade

Very Poor CCC Caa Below Investment Grade

Very Poor D C Below Investment Grade

Standard and Poor’s has rated STX as BB-, in contrast, DUK is

rated A-

The bond rating agencies have come under heavy criticism

during the recent credit crisis. Generally the criticism has

focused on:

Bond rating changes have not been timely (Downgrades

after a company had defaulted or declared bankruptcy)

Lack of an independent perspective (Bond rating agencies

are paid a fee by the debt issuer)