Case Study: Polaroid in 1996Polaroid faces several business risks in March of 1996 that will affect its financing policy. Traditionally a one-product-line company, Polaroid still derives 90% of its revenues from photographic products.
Although the company enjoys a de facto monopoly on instant chemical photography, digital imaging technologies pose a substantial threat. It is not clear how fast these technologies will develop or displace conventional photography, but it is clear that Polaroid will not have a monopoly in these markets. And the growth of quick "one-hour" photo development processing could make instant photography less appealing to consumers.
Further, an increasing portion of Polaroid's revenues come from outside the United States. Many of the sales are in developing countries: Russia alone accounted for almost 9% of 1995 sales. Polaroid does not have a large installed base in these countries, and the Polaroid brand name may not be as strong as in the United States. Although Polaroid uses international lines of credit and possibly other hedging techniques to reduce currency risk, doing business in developing nations poses an increased market risk.
The growth in international business is a logical move for Polaroid given that U.S. sales are flat and net margins of foreign sales have been higher than domestic margins for the past three years.
The increased risk and the possibility that the company will need additional funds to develop or acquire new technologies in the near future mean that Polaroid must maintain a strong enough balance sheet to provide a cushion for future financing needs.
To assess Polaroid's options, it is useful to know the firm's cost of capital. The company's bonds have a BBB rating, and Hudson Guaranty estimates the average BBB-rated issuer has a cost of debt of 7.40% and a cost of equity of 10.5%.
Polaroid's outstanding notes and debentures have a weighted average yield of 7.95%. Using the CAPM model with a beta of 1.05, a risk-free rate of 5.49%, and a risk premium of 11.5 - 5.49 = 6.01%, the required return on equity is 11.8%. These are consistent with the Hudson Guaranty estimates for the firm.
Exhibit A shows the calculation of Polaroid's weighted-average cost of capital at 10.03%.
Current stock price
Polaroid has been engaged in a process of buying back stock since 1989. This policy slowly increases the debt/book capitalization ratio and signals the market that management is confident of the company's future prospects. However, even taking management's forecasts of free cash flows and discounting them at 10.03% with a terminal growth rate of 3.6% after 2000, the current value of Polaroid's equity is $884 million, or $19.42/share. Since the market value on December 31, 1995 was $47.38/sahre, it appears that the market is overvaluing Polaroid's stock.
Exhibit C shows the sources and uses of cash as derived from Polaroid's projected income statements. This projection assumes the revolving lines of credit are maintained at current levels. Over $140 million in external financing will be required in both 1997 and 1999 and $92.5 million in 2004 as Polaroid's outstanding bonds mature. Polaroid could use additional debt to find its needs or additional equity, or some combination of debt and equity. Exhibit J is a brief FRICT analysis of debt and equity options for Polaroid.
Convertible debt is probably inappropriate for Polaroid. The main advantage of convertibles is their lower interest rate. However, the discount from normal interest rates would depend on the firm's growth opportunities and on investor's assessments of the likelihood of increases in share price. Since Polaroid does not expect significant growth in earnings in the near future and since the stock price already rose substantially in 1995, it is unlikely that the share price will increase n the near future. Therefore, the difference in interest rate that a convertible bond would bring is probably not substantial.
Exhibit D shows the pro forma income statements based on issuance of equity to cover external funding needs. This is analogous to case Exhibit 6 in which the rollover of debt is assumed. Exhibit E shows selected ratios for each year under the all-debt and all-equity scenarios. Although an equity issue would send a negative signal to the market, the fact that Polaroid's stock is trading at a substantially higher price than it appears tobe worth means that this is essentially a cheap way to raise money. If Polaroid finances all of its cash needs through 2000 with equity, the book value of the equity will increase by $263.2 million, or 37%. Since the price on March 29, 1996 was $44.00/share, a conservative estimate of the issue price is $38/share. The compay would therefore issue 6.92 million shares under the all-equity plan.
Combination of debt and equity
Since even maintaining the current debt levels does not cause Polaroid to fall below a BBB rating if it earns its projected income, it might be unnecessarily conservative to go to too low a debt level and lose the benefits of leverage. A partial paydown on the long-term debt with equity followed by a rollover of remaining debt in future years is a viable option that preserves the benefits of debt and still allows Polaroid substantial flexibility. Exhibit F shows the projected income statements when $200 million in equity is issued in 1997 with $126.1 million in long-term debt rollovers in 1998.
Norwood estimates that a worst-case scenarios with EBIT falling to $150 million per year. Exhibit G is a pro forma income statement with EBIT at $150 million every year from 1996 to 2000. The sources and uses of cash estimate (Exhibit C) includes this scenario, and Exhibit H shows pro forma income statements with equity financing. Under this scenario, the debt ratios are still not alarming enough to pull Polariod's credit rating below BBB.
Exhibit I shows a calculation of the projected earnings per share of common stock relative to the EBIT that Polaroid will generate in 2000. Under the projected sales and income, debt financing yields a higher EPS. The breakeven point is at $219.2 million in EBIT. This is about halfway between projected EBIT of $288 million and worst-case $150 million.
Under a middle-of-the-road approach of $200 million in equity, the EPS is $3.12.
Polaroid should do the following:
- Stop buying back its stock
- Issue $200 million in equity in 1996
- Fund the remainder of its needs through 2000 ($126.1 million) with 5-year bonds.
In 1995, the yield curve appears to be flat, so there would be no significant decrease in interest payments from going to longer bonds. Although interest rates could be locked in with longer bonds, there is no compelling economic reason to extend maturity. Indeed, for flexibility reasons, it may be preferable to go with shorter bonds or to make any new bonds callable.
It is interesting to note that the Hudson Guaranty estimates of capital costs in Exhibit 11 and the median financial ratios in Exhibit 9 indicate that the lowest industry WACC is enjoyed by firms with BBB-rated bonds. So Norwood has good reason to prefer this bond rating if he can be assured that he can maintain it. If Polaroid's debt raio rises or interest coverage declines significantly, its credit rating could decline to below investment grade. Such an event would damage the company's ability to raise capital in the future. Given both the increases in Polaroid's sales risk and the possible requirement for investment capital to fund new product development in the next few years, it is advisable to maintain a debt/equity ratio lower than necessary to maintain a BBB rating. This cushion will give Polaroid the flexibility it needs.