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Assuming a stock price of $50 before the start of the restructuring, the initial value of the unleveraged part of OCF is Vu = 29,695,000($50) = $1,485,000,000 Let tc = 34 be the corporate tax rate and B = $2,079,000,000 the amount of new debt With the issuance of the new debt the new value of OCF is VL = Vu + tcB = 1,485,000,000 + 34(2,079,000,000) = 1,485,000,000 + 707,000,000 = $2,192,000,000 This calculation assumes the entire debt proceeds are given to the shareholders We want to determine the value of the stock equity Assuming a distribution of $2,079,000,000 to stockholders and new debt of $2,079,000,000, we have Stock = VL- Debt = 2,192,000,000 - 2,079,000,000 = $113,000,000 If all shares were exchanged, the new number of shares is 29,695,000 The new value per share is $381:
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Value per share =
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This is only an estimate (an approximation) since the numerator can be increased by including gains in efficiency, thus further increasing the value per share Also, not all shares will be exchanged for the package Some shares controlled by management will be exchanged for new shares of common stock With the projected stock price of $381 (rounded to $4), and the value of a debenture rounded to $18, the total value received by a stockholder in exchange for one share of old stock is
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C a s h $ 5 2 Debentures 18 Common stock 4 Value of package $74
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If the initial stock price were $57 rather than $50, the value of Vu would be $1,693,000,000 and the value with the issuance of $2,079,000,000 of debt is VL = 1,693,000,000 + 707,000,000 = $2,400,000,000 and the value of the stock equity after the distribution of $2,079,000,000 to stockholders and the debt issuance is VL - debt = 2,400,000,000 - 2,079,000,000 = $321,000,000 The new value per share is
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Value per share = Now, rounding the $1081 to $1100 the shareholders receive in exchange for one share: Value received = 52 + 18 + 11 = $81 The $57 initial stock price is probably too high an estimate of value
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THE VALUE OF EXECUTIVE STOCK OPTIONS
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Assume a corporate financial restructuring includes the substitution of debt for equity This increase in leverage increases the risk to common stock (the variance of return on equity and the variance of earnings per share and the stock's beta) and thus, all things equal,
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148 _____________________________________________ PRIVATE EQUITY
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the increase in leverage increases the value of outstanding stock options The value of outstanding executive stock options is increased as the result of the substitution of debt for common stock if the debt proceeds are used to reduce the number of outstanding shares We make the simplifying assumption that the Black-Scholes (1973) option pricing formula applies (if the options are issued by a firm paying a cash dividend, the formula does not apply exactly) While each financial restructuring is different, thus the option wealth effect is different, the substitution of debt for equity is a common element of restructurings Also the form of the restructuring (cash dividends compared to share repurchase) can affect the value of an executive stock option even if the exercise price is kept equal to the stock price The share repurchase alternative results in a higher stock price than with a cash dividend (of equal amount in total), thus increases the value of a stock option with a given exercise price The value of the option is increased by the increase in the standard deviation resulting from debt issuance, but the option value also depends on the share price after restructuring, which in turn depends on whether the debt amount is distributed in the form of a dividend or in the form of a share repurchase The larger the share price, if the exercise price is kept constant, the larger the new option value Each outstanding option was adjusted by OCF to enable the holder to purchase 56 new common shares and the "exercise price will be adjusted accordingly" The adjustment to the exercise price was not revealed to the public Management (150 employees) were given the right to purchase 850,000 new common stock at fair market value They were also awarded 1,400,000 new common shares (vested over five to seven years or less) and options to purchase 1,400,000 new common stock (exercise price equal to market price at date of grant) These options vest in five years or less As a result of all the above, management will control approximately 245 percent of the new common stock outstanding after the recapitalization This is a larger percentage of ownership than many managements own after an LBO Thus, we can call this transaction a partial LBO or a form of managerial buyout (MBO) WW Boeschenstein before recapitalization had access to
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122,684 shares (owned, options, and employee stock plan accounts) After the recapitalization he had access to 428,435 shares Of course, the new shares had significantly less value per share than the old shares To be fair to the ESOP and comparable plans the company promised that the number of shares given will be equal to or exceed in value the value of a debenture plus $52 cash Thus if the stock price is $15 after the Recapitalization, and the value of the debenture is $17, the ESOP would receive 46 new shares
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It would also have the one old share, so it would have 56 shares As a result of the recapitalization long-term debt increased from $543 million (at the end of 1985) to $1,645 million (at the end of 1986) Current liabilities went from $548 million to $1,310 million On the other hand, stock equity went from $945 million to a deficit of $1,025 million The OCF's net income was $131 million for 1985 and $16 million for 1986 (there were $200 million of restructuring costs and a $50 million increase in borrowing costs) The stock of OCF prospered from 1986 to the late 1990s (with some ups and downs) For example, in 1992, it realized a low of $22 and a high of $40 Unfortunately, in the year 2000 asbestos liabilities grew exponentially and the company entered bankruptcy
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CONCLUSIONS__________________________
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Corporate restructurings where there are managerial stock options outstanding typically lead to a change in the value of the managerial stock options Among the important decision variables are: II Whether the cash from the debt issuance is distributed to the shareholders in the form of a dividend or a share repurchase (the expected stock price is affected)
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