Polaroid Corp. 1996 (v. 1.7) Harvard Case Solution & Analysis

4.     Please verify which debt ratings can minimize the WACC of Polaroid with Exhibit 11. How do you evaluate the precondition which is “it is not important for investors that the leverage will change within the investment grade range”? If you have uncomfortable feeling, which method do you use for verification?

As per the calculations performed in Exhibit WACC, debt with credit rating of AAA provides the lowest weighted average cost of capital of 8.65% and the lowest weighted average cost of capital is a combination of lowest cost of equity and lowest cost of debt in proportion to their market values. Financing through lowest cost of weighted average cost of capital makes the investment safe and contributes to the maximization of shareholders value.

However, a precondition that investor is not concerned about the change in leverage ratios is not functional because investors investment will only be safe if the they are exposed to limited financial risk and changes in leverage will change the financial risk of business because the more the leverage ratio the less will be left for other investors if they have lower priority investments. In the mean time, equity investor will also be affected by the changes in leverage ratio although not in short term but in long term their investment will be at stake because more commitment to fixed amount of interest payment will undermine the residual profit that will be used for refinancing the business expansion or paid out to equity holder as dividends. In addition to this, high financial risk caused by the high leverage ratio will also affect the market share price of equity shares and bonds, which will result in capital losses in long run and in case of excessively high leverage ratio, the company may not be able to meet its interest commitment; which can lead to bankruptcy of company and in case of liquidation equity holders will be ranked at the end and if there is nothing left after payment of outstanding debts then they will lose all their invested money. Therefore, the precondition is not an appropriate condition and investors should give weight to the leverage ratio while evaluating an investment opportunity.

  • 5.     If you were Ralph Norood. What kind of financial policies do you propose to the board members? Especially, please make a comprehensive plan regarding a) target rating category, b) Debt flexibility (Debt capacity), c) The balance of debt and equity d) Maturity date of debt e) Others.

Ralph Norood shall adopt a capital structure policy, which willenhance the value of the whole organization, facilitates flexibility and improves the bond rating because it will provide an opportunity for the organization to enjoy low interest rate.

a)      Target rating category

Polaroid shall target the bond rating at BB credit rating because it has a WACC of 9.49%, which is substantially lower than other figures in the credit ratings. Further, the debt will provide additional funds to the organization to cope with any future requirements. Further, it will also provide an opportunity in future to adjust against any critical circumstances in future.

b)      Debt flexibility

The company needs to step down from BBB credit rating in order to achieve flexibility. Further, it can also discourage the long term debt structure of the organization because major of its peers are above A credit rating in 1996. Second the benchmark of the industry refers only $655 million. Moreover, 1996 will be a transition year for the company because the new business strategy will incorporate new uncertainties, which may be worthwhile for the company’s future.

c)      The balance of debt and equity

Polaroid’s BB credit rating will show an interest coverage of 1.94 times, which is substantially less than the industry average of 3.94 times. Further, the long term debt capitalization of 25.2% is much less than the industry percentage of 55.6%, so it will be advisable for the firm to go with BB investment category, which have an interest coverage of 1.94 times and debt capitalization of 25.2%. Further, in order to avoid the risk of getting the credit rating further down, the organization shall play safe in adopting an appropriate restructuring structure and in order to avoid any negative effect on the brand image................................

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