SLOVO PRODUCTS VALUAT Natural Toys (NT) is a successful manufacturer of wooden toys and wood fur- niture for children. Though it has some overseas...
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QuestionsEstimate the market value of Slovo's debt.

  1. a) How would Slovo's unlevered cost of capital compare to that of Natural Toys? Explain.

   b)According to Miller and Modigliani (MM), what is NT's unlevered cost of capital?    (Note that NT exists in a no-tax world.)

  1. Given their current capital structure, do Slovo and Natural Toys have the same cost of capital? Explain.

 

  1. It is not clear from the case if the debt is transferable. That is, since the debt was offered on a concessionary basis, it may contain a "due on sale" clause so that if Natural Toys sold Slovo, it would have to pay off the debt. Would that affect your recommendation on what Natural Toys should do? If so, why and in what way?

 

  1. Do you recommend that NT use debt or equity to raise the $1 million necessary to purchase Slovo? Defend your choice.

 

  1. The purchase of Slovo can be likened to the purchase of an option. Discuss.

 

  1. a) Based on the information in the case, Slovo will generate a cash flow of $300,000 per year for the stockholders of Natural Toys. Explain how this was derived.

 

  b) What is the appropriate discount rate to use when calculating the present value of these cash flows? What is the present value at that interest rate?

 

8. Should Natural Toys make the purchase? Defend your recommendation.


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SLOVO PRODUCTS VALUAT Natural Toys (NT) is a successful manufacturer of wooden toys and wood fur- niture for children. Though it has some overseas markets, all of its production facilities are in the United States, and its market is Overwhelmingly in the United States. It is therefore ironic that it is considering the purchase of Slovo Wood Products, a government-owned company located in Lithuania. Lithuania declared independence from the Soviet Union on March 11, 1990, and the last Soviet troops left in 1993. Lithuania is now a democratic nation which embraces private property and free enterprise. The transition was not without pain—the industrial output of state enterprises fell an estimated 60 percent—but the privatized companies are now expanding. The government has not been able to sell every company: Slovo Wood Products is one of the remaining firms. When Slovo's customers got a chance to buy relatively cheap, high-quality competing foreign products, they turned away from Slovo in droves. Slovo has struggled to stay alive, and its current existence can best be described as zombie-like. The company made no profits in 1995, though they were able to cover their cash costs. The operating rate has been deteriorating as the old machinery breaks down more and more often, and the plant now runs only a third of the time because of frequent breakdowns. The government is anxious to get rid of this facility; it has offered to sell the company for $1 million which will go directly into the company to purchase new equipment and increase working capital. Slovo, however, will come encumbered with $10 million in 20-year debt which bears an 8 percent rate of interest. This is not a market-determined rate, but rather represents special concessionary financing which is offered as part of the deal. Basically, the government has been loaning Slovo money for years, and this is a "work out" to them. That is, the gOvernment gives a lower-than-market interest rate and generous repayment terms. There is no sinking fund required on the debt. The annual interest payment is 8 percent and NT's management estimates that the

market rate on this debt is 12 percent. Interest payments are due at the end of each of the next twenty years. NT will buy the firm through a shell subsidiary so that the parent corpora- tion will not be responsible for the firm if default occurs. In other words, NT will set up a separate subsidiary, Natural Toys/ Lithuania. NT will own all the stock of Natural Toys/ Lithuania, but it will not be responsible for any of their debts. They are in the same position and enjoy the same protection as any other shareholder—if Natural Toys / Lithuania goes belly up, NT will not be respon- sible for any of their subsidiary's debts. Slovo Wood is a very attractive prospective to NT. First, Slovo produces a number of products which, with some modifications, can supply the NT plants in the United States. Slovo has the advantages of abundant supplies of raw materials as well as relatively low—cost labor (wages average about $100 per month). The production facilities are, to be sure, out of date and use too much labor by American standards. However, the lower cost of labor in Lithuania makes this much less of a problem. Also, the government will allow NT to fire up to half the employees if it takes over the firm. While mass firing may seem like pretty stern medicine, it is probably neces- sary; Slovo Wood has far too many people and cannot continue losing money at the present rate. With fewer employees, more effective equipment, and NT's tech— nical expertise, Slovo will quickly become a low-cost—and profitable—producer. Management expects that sales will be $20 million a year for the next twenty years. Slovo's operating margin, that is, (EBIT + Dep.)/ sales, is estimated to be 6.5 percent, and capital spending to replace equipment will run 1 percent of sales per year. Principal on the 8-percent $10 million loan from the Lithuanian government is not due until the end of year 20, and at that time Slovo's termi— nal value is estimated to equal the debt due. Taxes are not a consideration. In the 19805, NT made a number of ill—fated attempts to diversify, and the resulting losses earned NT such a large tax carry- over that NT can ignore taxes. NT figures that its own cost of capital is about 11 percent, comprised of 25 percent debt at an 8 percent cost and 75 percent equity with a cost of 12 percent. Despite the fact that Slovo is located in a different country, NT will use it as a parts supplier to its own operations, so it feels that the business risk is about the same. And though there is some currency exposure and potential losses on currency fluctuations, these risks are likely to be small because the government has adopted a policy of tying the currency (called the litas) to the dollar. In any case, if the litas depreciates, NT will just get its supplies at a cheaper price in dollars. And while Lithuania's currency might appreciate, it is not likely; Lithuania's economy is pretty much flat on its back and economic progress will be slow for quite a while. On balance, NT is willing to ignore the currency risk. NT realizes that Slovo may be risky but it figures that even if Slovo goes belly up, they will have all their cash back in a little over three years, and they can just walk away from the project. Of course, if Slovo turns out well, then management knows that it will probably put in more investment and expand output. For the time being, however, they like the idea of making this wager.

market rate on this debt is 12 percent. Interest payments are due at the end of each of the next twenty years. NT will buy the firm through a shell subsidiary so that the parent corpora- tion will not be responsible for the firm if default occurs. In other words, NT will set up a separate subsidiary, Natural Toys/ Lithuania. NT will own all the stock of Natural Toys/ Lithuania, but it will not be responsible for any of their debts. They are in the same position and enjoy the same protection as any other shareholder—if Natural Toys / Lithuania goes belly up, NT will not be respon- sible for any of their subsidiary's debts. Slovo Wood is a very attractive prospective to NT. First, Slovo produces a number of products which, with some modifications, can supply the NT plants in the United States. Slovo has the advantages of abundant supplies of raw materials as well as relatively low—cost labor (wages average about $100 per month). The production facilities are, to be sure, out of date and use too much labor by American standards. However, the lower cost of labor in Lithuania makes this much less of a problem. Also, the government will allow NT to fire up to half the employees if it takes over the firm. While mass firing may seem like pretty stern medicine, it is probably neces- sary; Slovo Wood has far too many people and cannot continue losing money at the present rate. With fewer employees, more effective equipment, and NT's tech— nical expertise, Slovo will quickly become a low-cost—and profitable—producer. Management expects that sales will be $20 million a year for the next twenty years. Slovo's operating margin, that is, (EBIT + Dep.)/ sales, is estimated to be 6.5 percent, and capital spending to replace equipment will run 1 percent of sales per year. Principal on the 8-percent $10 million loan from the Lithuanian government is not due until the end of year 20, and at that time Slovo's termi— nal value is estimated to equal the debt due. Taxes are not a consideration. In the 19805, NT made a number of ill—fated attempts to diversify, and the resulting losses earned NT such a large tax carry- over that NT can ignore taxes. NT figures that its own cost of capital is about 11 percent, comprised of 25 percent debt at an 8 percent cost and 75 percent equity with a cost of 12 percent. Despite the fact that Slovo is located in a different country, NT will use it as a parts supplier to its own operations, so it feels that the business risk is about the same. And though there is some currency exposure and potential losses on currency fluctuations, these risks are likely to be small because the government has adopted a policy of tying the currency (called the litas) to the dollar. In any case, if the litas depreciates, NT will just get its supplies at a cheaper price in dollars. And while Lithuania's currency might appreciate, it is not likely; Lithuania's economy is pretty much flat on its back and economic progress will be slow for quite a while. On balance, NT is willing to ignore the currency risk. NT realizes that Slovo may be risky but it figures that even if Slovo goes belly up, they will have all their cash back in a little over three years, and they can just walk away from the project. Of course, if Slovo turns out well, then management knows that it will probably put in more investment and expand output. For the time being, however, they like the idea of making this wager.

market rate on this debt is 12 percent. Interest payments are due at the end of each of the next twenty years. NT will buy the firm through a shell subsidiary so that the parent corpora- tion will not be responsible for the firm if default occurs. In other words, NT will set up a separate subsidiary, Natural Toys/ Lithuania. NT will own all the stock of Natural Toys/ Lithuania, but it will not be responsible for any of their debts. They are in the same position and enjoy the same protection as any other shareholder—if Natural Toys / Lithuania goes belly up, NT will not be respon- sible for any of their subsidiary's debts. Slovo Wood is a very attractive prospective to NT. First, Slovo produces a number of products which, with some modifications, can supply the NT plants in the United States. Slovo has the advantages of abundant supplies of raw materials as well as relatively low—cost labor (wages average about $100 per month). The production facilities are, to be sure, out of date and use too much labor by American standards. However, the lower cost of labor in Lithuania makes this much less of a problem. Also, the government will allow NT to fire up to half the employees if it takes over the firm. While mass firing may seem like pretty stern medicine, it is probably neces- sary; Slovo Wood has far too many people and cannot continue losing money at the present rate. With fewer employees, more effective equipment, and NT's tech— nical expertise, Slovo will quickly become a low-cost—and profitable—producer. Management expects that sales will be $20 million a year for the next twenty years. Slovo's operating margin, that is, (EBIT + Dep.)/ sales, is estimated to be 6.5 percent, and capital spending to replace equipment will run 1 percent of sales per year. Principal on the 8-percent $10 million loan from the Lithuanian government is not due until the end of year 20, and at that time Slovo's termi— nal value is estimated to equal the debt due. Taxes are not a consideration. In the 19805, NT made a number of ill—fated attempts to diversify, and the resulting losses earned NT such a large tax carry- over that NT can ignore taxes. NT figures that its own cost of capital is about 11 percent, comprised of 25 percent debt at an 8 percent cost and 75 percent equity with a cost of 12 percent. Despite the fact that Slovo is located in a different country, NT will use it as a parts supplier to its own operations, so it feels that the business risk is about the same. And though there is some currency exposure and potential losses on currency fluctuations, these risks are likely to be small because the government has adopted a policy of tying the currency (called the litas) to the dollar. In any case, if the litas depreciates, NT will just get its supplies at a cheaper price in dollars. And while Lithuania's currency might appreciate, it is not likely; Lithuania's economy is pretty much flat on its back and economic progress will be slow for quite a while. On balance, NT is willing to ignore the currency risk. NT realizes that Slovo may be risky but it figures that even if Slovo goes belly up, they will have all their cash back in a little over three years, and they can just walk away from the project. Of course, if Slovo turns out well, then management knows that it will probably put in more investment and expand output. For the time being, however, they like the idea of making this wager.

market rate on this debt is 12 percent. Interest payments are due at the end of each of the next twenty years. NT will buy the firm through a shell subsidiary so that the parent corpora- tion will not be responsible for the firm if default occurs. In other words, NT will set up a separate subsidiary, Natural Toys/ Lithuania. NT will own all the stock of Natural Toys/ Lithuania, but it will not be responsible for any of their debts. They are in the same position and enjoy the same protection as any other shareholder—if Natural Toys / Lithuania goes belly up, NT will not be respon- sible for any of their subsidiary's debts. Slovo Wood is a very attractive prospective to NT. First, Slovo produces a number of products which, with some modifications, can supply the NT plants in the United States. Slovo has the advantages of abundant supplies of raw materials as well as relatively low—cost labor (wages average about $100 per month). The production facilities are, to be sure, out of date and use too much labor by American standards. However, the lower cost of labor in Lithuania makes this much less of a problem. Also, the government will allow NT to fire up to half the employees if it takes over the firm. While mass firing may seem like pretty stern medicine, it is probably neces- sary; Slovo Wood has far too many people and cannot continue losing money at the present rate. With fewer employees, more effective equipment, and NT's tech— nical expertise, Slovo will quickly become a low-cost—and profitable—producer. Management expects that sales will be $20 million a year for the next twenty years. Slovo's operating margin, that is, (EBIT + Dep.)/ sales, is estimated to be 6.5 percent, and capital spending to replace equipment will run 1 percent of sales per year. Principal on the 8-percent $10 million loan from the Lithuanian government is not due until the end of year 20, and at that time Slovo's termi— nal value is estimated to equal the debt due. Taxes are not a consideration. In the 19805, NT made a number of ill—fated attempts to diversify, and the resulting losses earned NT such a large tax carry- over that NT can ignore taxes. NT figures that its own cost of capital is about 11 percent, comprised of 25 percent debt at an 8 percent cost and 75 percent equity with a cost of 12 percent. Despite the fact that Slovo is located in a different country, NT will use it as a parts supplier to its own operations, so it feels that the business risk is about the same. And though there is some currency exposure and potential losses on currency fluctuations, these risks are likely to be small because the government has adopted a policy of tying the currency (called the litas) to the dollar. In any case, if the litas depreciates, NT will just get its supplies at a cheaper price in dollars. And while Lithuania's currency might appreciate, it is not likely; Lithuania's economy is pretty much flat on its back and economic progress will be slow for quite a while. On balance, NT is willing to ignore the currency risk. NT realizes that Slovo may be risky but it figures that even if Slovo goes belly up, they will have all their cash back in a little over three years, and they can just walk away from the project. Of course, if Slovo turns out well, then management knows that it will probably put in more investment and expand output. For the time being, however, they like the idea of making this wager.

EXHIBIT 1 The 1995 Income Statement of Slovo Wood Products ($ Millions) Sales$ $15.0 Cost of goods sold 105 Gross margin 45 Operating expenses 4.5 Depreciation 0.2 EBIT (0.2) Interest 0.8 Earnings before taxes (1.0) Taxes [1.0 Net income ($1.0)

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