Polaroid Corporation 1996 3h2x41

Financing Policy Case: Polaroid Corporation,  1996

Ten Years Financial Summary  (US$ Millions) Selected Income Statement Information Net Sales - US Net Sales - International Net Sales - Total Operating Expenses Profit from Opns. Before Restructuring Exp. Restructuring Expense Interest Expense Net Earnings Common Shares, End of Year (000s) Common Shares Repurchased (000s) Repurchase Outlay ($ millions) Common Shares Issued (000s) Earnings Per Share Dividend Per Share

1995

1994

1993

$1,019.0 1,217.9 2,236.9 2,147.7 89.2 247.0 52.1 -140.2 45,533 1,218 $40.2 753 -$3.09 $0.60

$1,160.3 1,152.2 2,312.5 2,112.2 200.3 0.0 46.6 117.2 45,998 941 $30.6 133 $2.49 $0.60

$1,178.8 1,066.1 2,244.9 2,059.5 185.4 44.0 47.9 -51.3 46,806 0 $0.0 138 -$1.10 $0.60

1992

1991

1990

1989

1988

1987

$1,145.7 $1,113.6 $1,058.3 $1,091.8 $1,048.3 $1,009.3 1,006.6 957.0 913.4 812.9 814.6 754.6 2,152.3 2,070.6 1,971.7 1,904.7 1,862.9 1,763.9 1,938.5 1,824.0 1,687.4 1,600.5 1,689.1 1,610.1 213.8 246.6 284.3 304.2 173.8 153.8 0.0 0.0 0.0 40.5 151.9 0.0 58.5 58.4 81.3 86.2 29.0 15.0 99.0 683.7 151.0 145.0 -22.6 125.2 46,668 48,919 50,070 52,110 71,635 61,918 2,258 1,151 2,040 19,525 0 0 $63.4 $30.6 $55.6 $950.6 $0.0 $0.0 7 0 0 0 9,717 0 $2.06 $12.54 $2.20 $1.96 -$0.34 $2.02 $0.60 $0.60 $0.60 $0.60 $0.60 $0.60 3

Ten Years Financial Summary (US$ Millions)

Selected Balance Sheet Information Working Capital Net Property, Plant & Equipment Total Assets Long-Term Debt Redeemable Preferred Stock Common Stockholders' Equity Addns. to Property Plant and Equip. Depreciation Book Value LT Debt/Capital Market Value LT Debt/Capital

1995

1994

1993

1992

1991

1990

1989

1988

1987

$738.5 691.0 2,261.8 526.7 0.0 717.7 167.9 $132.7 42.3% 19.6%

$886.8 747.3 2,316.7 566.0 0.0 864.4 146.7 $118.2 39.6% 27.5%

$833.6 718.2 2,212.3 602.3 0.0 767.3 165.6 $100.3 44.0% 27.8%

$789.0 657.3 2,008.1 637.4 0.0 808.9 201.5 $89.1 44.1% 30.5%

$695.3 549.4 1,889.3 471.8 0.0 772.9 175.8 $85.5 37.9% 26.6%

$609.1 461.0 1,701.3 513.8 348.6 207.7 120.9 $87.2 48.0% 25.3%

$642.0 430.9 1,776.7 602.2 321.9 148.8 94.5 $87.4 56.1% 28.5%

$980.0 433.8 1,957.2 402.3 0.0 1,011.5 127.0 $81.9 28.5% 23.4%

$652.6 359.6 1,599.4 0.0 0.0 1,048.2 116.6 $75.7 0.0% 0.0% 4

Ten Years Financial Summary (US$ Millions) 1995 1994 1993 1992 1991 1990 1989 1988 1987 Selected Valuation Information (at years' ends) Polaroid Stock Price S&P 500 Index Polaroid Average P/E (1) S&P Industrials Average P/E (1) Polaroid Market/Book Ratio Polaroid Beta Yield on 30-Year T-Bonds Yield on 90-day T-Bil s Total Annual Return on Large Co. Stocks

$47.38 615.93 12.1 15.2 3.01 1.05 6.88% 5.49% 33.00%

$32.50 459.27 13.3 15.5 1.73 1.05 7.37% 4.25% 1.30%

$33.50 466.25 15.6 18.4 2.04 1.15 6.59% 3.00% 9.90%

$31.13 435.71 14.2 19.8 1.80 1.15 7.67% 3.43% 7.67%

$26.63 417.09 12.2 19 1.69 1.20 8.14% 5.38% 30.55%

$23.38 330.22 15.6 14.4 5.63 1.25 8.61% 7.50% -3.17%

$22.88 353.40 21.8 12.6 8.01 1.25 8.45% 8.11% 31.49%

$18.38 277.72 NMF 10.8 1.30 1.25 8.96% 6.67% 18.81%

$11.88 247.08 14.7 15.3 0.70 1.20 8.59% 5.78% 5.23% 5

Income Statement: Consolidated  Statement of Earnings (in $ Millions) 1995 Net Sales United States International Total Net Sales Cost of Goods Sold Marketing, Research, & . Restructuring & Other. Total Costs Profit/(Loss) from Operations Interest Income Other Income Interest Expense Earnings/(Loss) Before Taxes Tax Expense Net Earnings/(Loss)

1994

1995 1994

$1,019.0 $1,160.3 46 1,217.9 1,152.2 54 2,236.9 2,312.5 100 1,298.6 1,324.2 58 849.1 788.0 38 247.0 0.0 11 2,394.7 2,122.2 107 -157.8 200.3 -7 8.7 9.7 0 -0.2 -2.7 0 52.1 46.6 2 -201.4 160.7 -9 -61.2 43.5 -3 -140.2 117.2 -6

50 50 100 57 34 0 92 9 0 0 2 7 2 5

6

Balance Sheet (in $ Millions) Assets Current Assets Cash and Cash Equivalents Short-Term Investments Receivables, less allowances Inventories Prepaid Expenses and Other Total Current Assets Gross Property Plant and Equipment Less Accumulated Depreciation Net Property, Plant and Equipment Prepaid Taxes -- non-current Total Assets

1995

1994

$73.3 9.8 550.4 615.5 208.5 1,457.5

$143.3 85.6 541.0 577.4 141.4 1,488.7

2,164.4 2,043.4 1,473.4 1,296.1 691.0 747.3 113.3 80.7 $2,261.8 $2,316.7

1995 1994

3 0 24 27 9 64 96 65 31 5 100

6 4 23 25 6 64 88 56 32 3

100 7

Balance Sheet (in $ Millions) Liabilities and Stockholders' Equity Current Liabilities Short-Term Debt Current Portion of Long-Term Debt Payables and Acrruals Com pens ation & Benefits Taxes Payable Total Current Liabilities Long-Term Debt Accrued Pos tretirem ent Benefits Accrued Pos tem ploym ent Benefits Total Liabilities Preferred Stock Com m on Stockholders ' Equity Com m on Stock (1) Additional Paid-In Capital Retained Earnings Les s Treas ury Stock, at Cos t Les s Deferred Com pens ation Total Com m on Stockholders Equity Total Liabilities and Stockholders ' Equity

1995

1994

$160.4 39.7 274.9 197.4 46.6 719.0 526.7 257.2 41.2 1,544.1 0.0

$117.1 35.9 275.7 121.4 51.8 601.9 566.0 247.2 37.2 1,452.3 0.0

75.4 75.4 401.9 387.2 1,525.8 1,692.1 1,205.4 1,174.5 80.0 115.8 717.7 864.4 $2,261.8 $2,316.7

1995 1994

7 2 12 9 2 32 23 11 2 68 0 0 3 18 67 53 4 32 100

5 2 12 5 2 26 24 11 2 63 0 0 3 17 73 51 5 37 100

8

Financing Working‐ capital line  of credit

• 5‐year $150 million • To be used for general purpose • Set to expire in 1999 • 1994‐95 – no borrowing in this  line

Notes

ESOP Loan

International  line of  credits

• To  the firm’s foreign  currency balance sheet exposure • End 1994 – borrowings outside  US were $160.4 million • Unused borrowings under these  lines of credit were $160 million

Convertible  subordinated  debentures

• $150 million, 7.25% notes due Jan 15, 1997 • Issued at a discount (YTM 7.42%) • $200 million, 8% notes were due March 15, 1999 • Had been issued with a  discount of YTM 8.18% • Both issues were non‐callable

• • • •

Had been drawn in 1988 To establish PC’s leveraged ESOP As part of leveraged recapitalization of the firm Scheduled principal payments were made semiannually through 1997 when a final payment  of $37.7 million was due • Weighted average interest on the loan.., • 1995 – 5.2% • 1994 – 4.4% • 1993 – 3.6% • Special tax benefits to providers of ESOP loans ed for the unusually low interest rates

• • • •

$140 million, 8% convertibles due in 2001 Annual interest rate of 8% Convertible to common stock at $32.50 per share Redeemable by the company after Sept 30, 1998, or sooner if the stock prices exceeded  $48.75 per share for 20 or 30 consecutive trading days • All of the debentures were held by Corporate Partners

Optimizing Financing Mix Firm Value

Approaches

Financial  Flexibility WACC

Operating Income Approach

• OIA

Cost of Capital Approach

• CoC

Adjusted Present Value Approach

• APV

Return Differential Approach

• RD

Comparable Approach

• CA

Constraints • Voting Control • Investment Grade Rating

Value Free Cash Flow WACC Terminal Growth rate Terminal Value Total Free Cash Flow PV of FCF DCF Less: Debt Equity Value Outstanding Shares Intrinsic Value per Share Recent Share Price of Price vs. Value Market is in  because of.., Betting on beneficial effects of a  new CEO Substantial improvements in profit  margins Notable success in emerging  markets Possibility on new products Gets an opportunity to sell overvalued stocks

1996 120.8 10%

1997 94.3 10%

1998 99.2 10%

1999 105.1 10%

120.8 110 2,095 726.8 1,368 45.5 30.06 47.38 37%

94.3 78

99.2 75

105.1 72

2000 103.1 Ex. 6 10% Assumed 6% Assumed 2732.15 2835.25 1,760

Ex. 6

AAA AA A BBB BB B WACC (Market Weights) - Hudson WACC (Market Weights) - CAPM DCF - Hudson DCF - CAPM

9.60% 10.58% 2,322 1,837

9.41% 10.43% 2,448 1,896

9.28% 10.30% 2,540 1,952

9.08% 10.14% 2,705 2,025

9.67% 10.11% 2,278 2,040

10.13% 10.24% 2,030 181,979

Firm Value

Adjusted  PV

Without Taxes

With Taxes

Value of the Firm

VL = VU

VL = VU + tD

WACC

rWACC = 

rWACC = 

Cost of Equity

Firm Value = (47.38*75.4)+(726.8*40%) – Financial Distress Cost

1 1

Firm Value

Adjusted  PV

Valuing Put Option Price of Underlying Asset Firm Value ($MM) Face value of debt Exercise price ($MM) Volatility of Volatility opertaing income or share price Term of Debt Life of option Should be contemporaneous Risk free rate with the life of option (~5 years) Put Option Value Using BSM

Firm Value = (47.38*75.4)+(726.8*40%) – 3627.579 = 235.6 

4299.252 726.8

34.79% 3.62

6% 3627.579

WACC

Cost of  Capital

AAA AA A BBB BB B Cost of Debt (pre-tax) 6.70% 6.90% 7.00% 7.40% 9.00% 10.60% Ex. 11 Cost of Equity 10.25% 10.30% 10.40% 10.50% 11.75% 13.00% Ex. 11 Hudson Guaranty's Estimates of Equity Costs Cost of Debt (after tax of 40%) 4.02% 4.14% 4.20% 4.44% 5.40% 6.36% Estimated Cost of Equity 10.25% 10.30% 10.40% 10.50% 11.75% 13.00% Ex. 11 Market/Book Ratio 3 3 3 3 3 3 Ex. 1 Debt/Capital (Book) 25.90% 33.60% 39.70% 47.80% 59.40% 69.50% Ex. 9 Debt/Capital (Market) 10% 14% 18% 23% 33% 43% Estimated Weight of Debt 10% 14% 18% 23% 33% 43% Weight of Equity 90% 86% 82% 77% 67% 57% WACC (Market Weights) 9.60% 9.41% 9.28% 9.08% 9.67% 10.13% Estimated WACC (Book Weights) 8.64% 8.23% 7.94% 7.60% 7.98% 8.39% Estimated 28

Cost of  Capital

WACC AAA CAPM and Levered Betas Cost of Debt (pre-tax) Current Levered Beta Debt/Equity (Market) Recent Debt/Capital (Market) ratio Recent Debt/Equity (Market) ratio Tax rate Unlevered Beta Relevered Beta Cost of Equity (Rf = 6.24%, EMRP = 5.4%) Cost of Debt (after 40% tax) Market/Book Ratio Debt/Capital(Book) Debt/Capital(Market) WACC (Market Weights) WACC (Book Weights) 10-year Treasury Bond Rate Implied rate of beta for varios ratings

6.70% 1.05 11.65% 24% 32% 40% 0.88 0.94 11.34% 4.02% 3 25.90% 10% 10.58% 9.44% 6.24% 0.74

AA

A

BBB

BB

B

6.90% 7.00% 7.40% 9.00% 10.60% Ex. 11 16.87% 24% 32% 40% 0.88 0.97 11.49% 4.14% 3 33.60% 14% 10.43% 9.02% 6.24% 0.75

21.95% 24% 32% 40% 0.88 1.00 11.63% 4.20% 3 39.70% 18% 10.30% 8.68% 6.24% 0.77

30.52% 24% 32% 40% 0.88 1.04 11.88% 4.44% 3 47.80% 23% 10.14% 8.32% 6.24% 0.79

48.77% 24% 32% 40% 0.88 1.14 12.40% 5.40% 3 59.40% 33% 10.11% 8.24% 6.24% 1.02

75.96% 24% 32% 40% 0.88 1.29 13.18% 6.36% 3 69.50% 43% 10.24% 8.44% 6.24% 1.25 eg. (10.25%-6 29

Cost of Equity

WACC

13.00% C o s t o f E q u it y

12.50% 12.00% 11.50%

CAPM

11.00%

Hudson

10.50% 10.00% 9.50%

10.80% 10.60% 10.40% 10.20% 10.00% 9.80% 9.60% 9.40% 9.20% 9.00%

C o s t o f C a p ita l

13.50%

CAPM -based WACC Hudson's WACCs

A

BBB BB

Rating Category

B

AA A AA A BB B BB

9.00% AAA AA

Cost of  Capital

Rating Category

WACC

A

Cost of  Capital

Financial  Distress

Signaling  Effects

Incentive  Effects

Event Clientele  Effects

B

A (20%)

B (60%)

Risk for  Lenders

Low*

High

Owners Risk

Low*

High

Credit Rating

High*

Low

Financial  Flexibility

High*

Low

WACC

?

?

PBIT Total Capital

ROE vs. Cost of  Equity

Return  Differential

Debt / Capital 25.90% 33.60% 39.70% 47.80% 59.40% 69.50% Cost of Debt AAA 6.70% AA 6.90% A 7% BBB 7.40% BB 9% B 10.60% AAA AA A BBB BB B ROE AAA AA A BBB BB B Cost of Equity AAA 11.34% AA 11.49% A 11.63% BBB 11.88% BB 12.40% B 13.18% AAA AA A BBB BB B

1996 187.53104 1796.8

1997 1998 1999 2000 232.5934 258.9463 274.1831 293.0259 1877.8 1974.6 2080.5 2197.8

465 604 713 859 1067 1249

486 631 745 898 1115 1305

511 663 784 944 1173 1372

539 699 826 994 1236 1446

569 738 873 1051 1305 1527

PAT@40% Tax Rate

31 42 50 64 96 132 156 146 138 124 91 55

33 44 52 66 100 138 200 189 180 166 132 94

34 46 55 70 106 145 225 213 204 189 153 113

36 48 58 74 111 153 238 226 216 201 163 121

38 51 61 78 117 162 255 242 232 215 176 131

ROE

11.74% 12.23% 12.70% 13.22% 12.54% 10.07%

14.37% 15.16% 15.93% 16.95% 17.34% 16.46%

15.36% 16.26% 17.14% 18.35% 19.13% 18.84%

15.44% 16.36% 17.25% 18.47% 19.29% 19.05%

15.65% 16.59% 17.50% 18.77% 19.67% 19.56%

% Spread

0.40% 0.74% 1.07% 1.34% 0.14% -3.11%

3.03% 3.67% 4.30% 5.07% 4.94% 3.28%

4.02% 4.77% 5.50% 6.47% 6.73% 5.66%

4.10% 4.87% 5.61% 6.59% 6.89% 5.88%

4.31% 5.10% 5.87% 6.89% 7.27% 6.38%

Debt

Interest Cost

Comparable Approach

BBB / Baa3

34

Financial Flexibility Required Ratios for Rating Category Pretax interest coverage (x) EBITDA Interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Pretax return on permanent capital (%) Operating income/sales (%) Long-term debt/capital (%) Total debt/capitalization incl. short-term debt (%) Market/Book value of equity ratio Market Value Debt/Capital

AAA

AA

A

13.50 17.08 98% 60% 29% 23% 13% 26% 3 10%

9.67 12.80 69% 27% 21% 18% 21% 34% 3 14%

5.76 8.18 46% 21% 19% 16% 32% 40% 3 18%

BBB BB

B

3.94 6.00 33% 7% 14% 14% 43% 48% 3 23%

1.17 2.16 13% -1% 9% 12% 66% 70% 3 43%

2.14 3.49 18% 1% 12% 14% 56% 59% 3 33%

Ex. 9 Ex. 9 Ex. 9 Ex. 9 Ex. 9 Ex. 9 Ex. 9 Ex. 9 Ex. 1 Estimated36

Financial Flexibility AAA AA Estimate of Unused Debt Capacity Long Term Debt Short Term Debt Current Maturities of Long Term Debt Total book value of Debt Market Value of Equity Enterprise Value Maximum Debt Implied by Rating Unused Debt Capacity at Current Rating Unused Debt Capacity until Investment Grade Rating is Lost (at BB)

A

BBB BB

527 160 40 727 2,158 2,885 301 -426

527 160 40 727 2,158 2,885 416 -310

527 160 40 727 2,158 2,885 519 -208

527 160 40 727 2,158 2,885 675 -52

527 160 40 727 2,158 2,885 946 219

645

529

427

271

0

B 527 160 40 727 2,158 2,885 1245 518

Ex. 4 Ex. 4 Ex. 4 $47.38*45. Estimated Estimated

-300 Estimated37

Financial Flexibility AAA Estimate of Interest Coverage Pretax Cost of Debt Interest Expense Normalized 5-year EBIT Downside EBIT (2 Sigma) Coverage ratio - Normalized EBIT Coverage ratio - Downside EBIT

AA

A

BBB

BB

B

6.73% 6.87% 7.04% 7.40% 9.10% 10.52% 20

29

37

50

86

131

244.24 244.24 244.24 244.24 244.24 244.24 150 150 150 150 150 150 12 9 7 5 3 2 7 5 4 3 2 1

If wanted to maintain financial reserves at $150 million, then PC cannot  borrow much more than it is borrowing now (727 million) 38

Is Recapitalization a Good Idea? Repurcha se

Recapita lization ESOP

Run out of profitable  and internal investment  opportunities

Common Long-Term Stockholders' Debt Equity 1995 526.7 717.7 1994 566 864.4 1993 602.3 767.3 1992 637.4 808.9 1991 471.8 772.9 1990 513.8 207.7 1989 602.2 148.8 1988 402.3 1011.5 1987 0 1048.2 1986 0 960.1

Undervalued Shares

Current BV D/C 42.33% 39.57% 43.98% 44.07% 37.90% 48.01% 56.13% 28.46% 0.00% 0.00%

BV D/C if $300 BV D/C if $300 Million for Million for Expansion Recapitalization 53.53% 87.54% 50.05% 76.61% 54.04% 84.36% 53.68% 81.78% 49.96% 81.70% 79.67% 193.07% 85.84% 200.04% 40.98% 63.05% 22.25% 40.10% 23.81% 45.45%

Higher Perception on  Manager Confidence of  Performance

Difference in BV D/C 34.01% 26.56% 30.32% 28.10% 31.73% 113.41% 114.20% 22.08% 17.84% 21.64%

Commitment on the  part of insiders not to  divert the resources of  the firm to other uses