ch18 - Chapter 18 - Solutions Overview: Problem Length {S}...

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Chapter 18 - Solutions Overview: Problem Length Problem #’s {S} 3,7 {M} 1, 2, 4 - 6, 8 - 10 Problems 1-3 deal with the takeover of Kraft by Philip Morris. If assigned together, they would require approximately 1 1/2 hrs of work. 1.{M}a. Before Kraft Consolidated Pretax interest coverage 1 10.64X 3.76X Long-term debt/total capital 2 28.11% 61.99% Cash flow/total debt 3 71.14% 23.14% 1 ($4,820+$500)/$500 $4,420+$1,600)/$1,600 2 $3,883/($3,883+$9,931) $15,778/($15,778+ $9,675) 3 ($2,820+$750+$100-$125) ($2,564+$1,235+$390-$125) ($3,883 + $1,100) ($15,778 + $ 1,783) b. Pretax interest coverage moves from the AA range to the BBB range. Long-term debt/total capital shifts from A to less than B. Cash flow/total debt declines from between A and AA to BB. c. Prior to the merger, Philip Morris debt would have a strong A rating based on these criteria. After the Kraft merger, BB would be appropriate based on these same criteria. 18-1
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2.{M} Note: The answers given below concern the effect of the merger on the probability of bankruptcy as predicted by Altman's models. It is not clear that ratio changes caused by external events (such as an acquisition) have the same predictive ability as those resulting from normal operations. The variables used in Altman's two models are listed below by category: 1977 model 1968 model Activity Sales to total assets Liquidity Current ratio Working capital to total assets Leverage and Equity (market) Equity (market) Solvency to debt to capital Times interest earned Profitability Return on assets Return on assets Retained earnings to Retained earnings to total assets total assets Earnings Variability Standard error of ROA Size Total assets Activity (1968 model) Sales to total assets Sales increased by $11,610 (approximately 33%) from $33,080 to $44,690 as a result of the merger. Although Exhibit 18P-1 does not provide the data directly, we can infer from the data available that the increase in assets would be greater. Debt plus equity increased 1 by $12,322. When we consider that current operating liabilities and other (nondebt) liabilities 1 Total debt + equity (post merger) = $1,783 + $15,778 + $9,675 = $27,236 (pre merger) = $1,100 + $3,883 + $9,931 = 14,914 Increase = $12,322 18-2
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also increased as a result of the merger, we can infer that total assets grew by at least $12,322. If, prior to the merger, the asset turnover ratio was greater than 1, then adding a given amount ($11,610) to the numerator and a larger amount to the denominator would reduce the ratio, increasing the likelihood of bankruptcy. If, on the other hand, the asset turnover ratio was less than 1 prior to the merger, then more information about actual asset levels is needed to determine the effect on this ratio. Liquidity (1977 model) Current ratio (1968 model) Working capital to total assets The information in Exhibit 18P-1 is insufficient to assess the impact of the merger on working capital and the current ratio. Leverage and Solvency (1977 model) Market value of equity to debt (1968 model) Market value of equity to capital Before the merger, Philip Morris' total debt was $4,983 billion ($1,100 + $3,883). As a result of the merger, total debt increased more than threefold to $17,561 million ($1,783 + $15,778). Unless the market value of equity increased by the same proportion [Philip Morris' market value actually decreased
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ch18 - Chapter 18 - Solutions Overview: Problem Length {S}...

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