Question number: 1 Why is Pablo Este considering obtaining long-term capital?

Pablo Este considered three purposes for obtaining the long term capital of 7.5 million. The first purpose was to pay down the companys present working capital line of credit. In theoretical term a line of credit basically means an amount of funds that are available from the bank for the ongoing working capital or the cash needs of a business. The amount that is raised is often used for daily operations such as inventory purchase, purchase small equipment, manage unexpected expenditures and to cover the cyclical business fluctuations. In case of Rosario Acero the total amount needed to pay down as working capital line of credit is 4.8 million. The company has maintained its line of credit with Banco de Sol of Buenos Aires. The line was maintained 2 percent higher than the average market rate since it was not backed by any collateral that is the receivable and inventory rather was supported by personal guarantee and commercial real estate. The second purpose of long term financing is to repay the long term debt. The long term debt that the company has pursued will mature in next 6 months; therefore it is high time for the company to make arrangements to pay its long term debts. The total amount of long term debt is $9, 75,000. This is also a form of credit which is purposefully used to purchase long term assets such as buildings and heavy equipments. For any company to have healthy financial results, its long term debt should be minimum. Therefore companies should try to keep them away from the debt burden. The third and final purpose of the long term financing is for capital improvement and general purposes. In capital improvement a company basically tries to enhance or improve certain property that increases the overall value of the company. The total amount detach for capital improvement is $1,725,000.

Pablo Este considered three purposes for obtaining the long term capital of 7.5 million. The first purpose was to pay down the companys present working capital line of credit. In theoretical term a line of credit basically means an amount of funds that are available from the bank for the ongoing working capital or the cash needs of a business. The amount that is raised is often used for daily operations such as inventory purchase, purchase small equipment, manage unexpected expenditures and to cover the cyclical business fluctuations. In case of Rosario Acero the total amount needed to pay down as working capital line of credit is 4.8 million. The company has maintained its line of credit with Banco de Sol of Buenos Aires. The line was maintained 2 percent higher than the average market rate since it was not backed by any collateral that is the receivable and inventory rather was supported by personal guarantee and commercial real estate. The second purpose of long term financing is to repay the long term debt. The long term debt that the company has pursued will mature in next 6 months; therefore it is high time for the company to make arrangements to pay its long term debts. The total amount of long term debt is $9, 75,000. This is also a form of credit which is purposefully used to purchase long term assets such as buildings and heavy equipments. For any company to have healthy financial results, its long term debt should be minimum. Therefore companies should try to keep them away from the debt burden. The

third and final purpose of the long term financing is for capital improvement and general purposes. In capital improvement a company basically tries to enhance or improve certain property that increases the overall value of the company. The total amount detach for capital improvement is $1,725,000. Question no. 2 How will the two financing alternative affect the performance of the firm? Please examine the financial forecasts contained in Exhibit 6 to Exhibit 12 in the case. The performance of the firm could be evaluated through various financial ratios and valuation of the two alternatives. The major financial ratios could be EPS (Earning per share), ROA (Return on Assets), ROE (Return on Equity), Debt ratio, and Interest Coverage Ratio. The values and the interpretation for two alternatives are as follows: 1. EPS (Earning per Share): EPS under Private Placement with Warrants 1996 $7.57 1996 $7.57 1997 $4.96 1997 $1.72 1998 $6.04 1998 $1.99 1999 $7.29 1999 $2.29 2000 $8.70 2000 $2.64 2001 $10.28 2001 $3.02 2002 $12.06 2002 $3.45

EPS under Equity Shares

EPS is computed by dividing earnings after interest and taxes by the number of shares outstanding. We can see that with private placement with warrants, companies' EPS is in increasing trend from 1997 to 2002. With the issue of debt, it is reasonable to increase the EPS because number of shares outstanding will remain constant. On the contrary, with the issuance of equity shares, though it is increasing trend but less than in terms of debt issuance. Keeping other things constant, debt issuance could add value to the firm through high EPS. 2. ROA (Return on Assets): ROA under Private Placement with Warrants 1996 7.93% 1996 7.93% 1997 4.06% 1997 6.44% 1998 1999 2000 2001 6.24% 2001 8.38% 2002 6.76% 2002 8.84% 4.60% 5.16% 5.70% ROA under Equity Shares 1998 6.93% 1999 7.43% 2000 7.91%

ROA of any firm is a measure of profit per dollar of assets. It is obtained by dividing net income by the total assets of the firm. From the above calculation, we can see that either use of debt or equity has no any such large effect on the profit per dollar of assets of Rosario.

3. ROE (Return on Equity): ROE under Private Placement with Warrants 1996 49.0% 1996 49.0% 1997 24.3% 1997 14.2% 1998 1999 2000 2001 19.5% 2001 13.7% 2002 18.6% 2002 13.5% 22.8% 21.6% 20.5% ROE under Equity Shares 1998 14.1% 1999 14.0% 2000 13.8%

ROE is a measure of how the stockholders fared during the year. ROE is, in an accounting sense, the true bottom line measure of performance. It is calculated by dividing net income by the total equity of any company. We can see that, with the use of either debt or equity does not have any greater effect on ROE. Instead, in both the cases ROE has decreased in comparison to the ROE of 49% of the year 1996. Valuation of two alternatives using Discounted Cash Flow Method: We have computed the value of both alternatives using the average unlevered beta from the Rosario's major competitors. The competitors are Acero Dali S.A. (AD), Colon S.A. (CSA), Greco Acero (GA), and Velasguez S.A. (VAZ). We have not considered Picasso Acero S.A (PI) to calculate the unlevered beta, since this company is going through losses in the most recent years. We have used similar method for both the private placement with warrants and equity shares to come up with the intrinsic price of share of Rosario. With the use of unlevered beta of competitors, Rosarios levered beta has been calculated. The same levered beta, with addition to risk free rate of 5.7% (3-month T-bill rate, case Exhibit 13), and risk premium of 4.54%, has been used to come up with return on equity (Re) for the firm by using equity as an alternative. We found risk premium by calculating nominal growth rate and deducting risk free rate from this nominal rate. We have assumed that the stock price grows with the growth in economic activity such as GDP (6%). With the use of various cost of equity in each year from 1997-1998, and a constant cost of debt of 10.5% (Exhibit 14), we have computed the WACC (Weighted Average Cost of Capital) for the company in each year. Then, these WACC has been averaged and used to discount the free cash flow in each year. Finally, we come up with the fair price per share of $95.77 for the Rosario's stock. (Calculation in Annex 1) With the same procedure and assumptions as in the case of issuance of equity, we have valued the debt for the company. The only difference is the use of cost of debt as the proportion of old as well as new debt. So in this case the cost of debt varies in each year. There is different WACC in this case which has been used to discount the forecasted cash flow. The fair price of stock comes to be a negative $29.20 if firm uses a debt with warrants financing. (Calculation in Annex 2)

Question number: 3 What are the principal risks the firm faces? Under some reasonable downside scenario, could Rosario Acero continue to service its debt? The principal risks that Rosario Acero S.A. faces are as follows: Debt-servicing risk: The forecasts resulting from the issue of debt gives following results:
Projected 1997 1.41 (1.71) 0.58
0.29

Free Cash Flow Less Interest Payments Interest Tax Shield Less Principal Payment Free Cash Flow to Equity Holders

1998 1.20 (1.68) 0.57

0.09

1999 1.33 (1.63) 0.55

0.25

2000 1.46 (1.56) 0.53

0.43

2001 1.61 (1.48) 0.50

0.63

2002 2003 1.78 1.96 (1.38) (1.39) 0.47 0.47 (1.88) 0.87 (0.83)

2004 2.16 (1.52) 0.52 (5.63) (4.46)

The above table shows that if Acero takeas on a private placement of eight-year notes, the cash flows are not enough to cover the payments of principal in year 2003 and 2004. As a result equity holders are provided with negative free cash flows. Therefore, the firm will need to make arrangements for refinancing for meeting the principal payment obligation. Single supplier: Acero relies on only one primary source for the scrap metal used in its production of rolls and castings located in Buenos Aires. The image of Acero will be deteriorated if the supplier is not able to supply. As a result, Acero will lose its customers and sales. Market fluctuation risk: The stock market of Argentina is tied up with South American markets. So, the volatility in South American markets can harm the Argentinas market.(Example: Mexican peso crisis had harmed the Argentinas market back in 1994) Strong covenant risk: The debt covenants require Rosario Acero to maintain its EBIT coverage of at least 2.0. This could be a greater risk for the firm in reaching the level of EBIT. In the case of reasonable downside scenario, the real GNP grows only by 1.5% with an inflation rate of 2.5%, yielding a real GNP growth rate of 4%. The forecast for annual rates of inflation is between 2.5% and 4% and for Real Gross National Product (GNP) is 1.5% to 6%. Rosario Acero financial statements projections have been based on a revenue growth rate of 10.3%. Lets assume that the sales projections have been based on optimistic forecasts of the economys growth. As per an optimistic projection, GNP growth rate will be 10%. ( 6% real GNP growth +4% inflation). From this we can inferred that when GNP growth rate = 4%, sales growth rate =4.12% on the basis of GNP growth rate= 10%, sales growth rate =10.3% The interest coverage ratio is still higher than 2 times for each of the forecast period even we use the sales growth rate of 4%,

Sales growth rate of 4.21%

Actual Projected 1996 1997 34.80 36.23 -27.65 -28.26 -3.96 -4.71
3.19 -1.10 2.09 0.00 2.09 1.76 7.57 2.90 3.26 -0.65 -0.98 1.63 -0.56 1.08 4.63 2.00

Revenues Cost of Goods Sold Selling, Generall, & Admin. Earnings Before Interest and Taxes Interest (Notes and Old Loans) (1) Interest (New Loan @ 13%) Profit Before Taxes Taxes Profit After Taxes Profit With Extraord. Item Earnings per Share EBIT/Interest

1998 37.73 -29.43 -4.90

3.40 -0.55 -0.98 1.87 -0.64 1.24 5.30 2.23

1999 39.28 -30.64 -5.11

3.54 -0.42 -0.98 2.14 -0.73 1.41 6.07 2.54

2000 40.90 -31.90 -5.32

3.68 -0.27 -0.98 2.43 -0.83 1.60 6.89 2.95

2001 42.58 -33.22 -5.54

3.83 -0.12 -0.98 2.74 -0.93 1.81 7.77 3.51

2002 44.34 -34.58 -5.76

3.99 0.06 -0.98 3.08 -1.05 2.03 8.71 4.36

From the table, it can be seen that Acero would still have ability to continue servicing its debt under the downside scenario (sales growth rate of 4.21%) Question number: 4 From Rosarios standpoint, are the terms of the notes and warrants package competitive and/or attractive? Rosario Acero S.A had been planning to issue senior notes with non detachable warrants; notes being issued at interest rate of 13% per annum payable semi-annually. The case also gives the base lending rate in the economy as 8.5% plus 2%. Hence looking it from the companys perspective, the notes are not attractive as the Rosarios coupon rate is 2.5 % higher than the base rate. Although this seems attractive from investors perspective, it is not from the standpoint of the company. As also highlighted in Exhibit 14; many companies in the similar industry are issuing debt at a rate higher than Rosario SA. Further, the terms and conditions of issuance prohibit the company to redeem it before maturity. That is the company cannot call the notes before 7th year. Such terms and conditions although protects the potential investors from increasing interest rate risk, it will not allow the company to take the advantage of potential decline of interest rate in the economy. Warrants is a certificate, usually issued along with a bond or preferred stock, entitling the holder to buy a specific amount of securities at a specific price, usually above the current market price at the time of issuance, for an extended period, anywhere from a few years to forever. In the case that the price of the security rises to above that of the warrant's exercise

price, then the investor can buy the security at the warrant's exercise price and resell it for a profit. Otherwise, the warrant will simply expire or remain unused. Generally, the attachment of warrants with the notes is viewed as a sweetener which increases the returns for the investors. The inclusions of warrants also benefit the company as it helps to reduce the coupon payments in the notes. But this is not the same in the given case. The inclusion of warrants has no changes in the companys coupon rates. The notes were being issued at high coupon rates of 13. Similarly, issue of warrants with notes threatens the existing shareholders position in the company, which might get diluted if the warrants are exercised. Question number: 5 As for the possible equity issue, would an offering p rice of $9 per share be fair? Before computing the fair value for the Rosario there are certain assumptions to be made for the company. We are not provided with clear information regarding expected growth. So, we have assumed the growth rate to be 6%. It is assumed that the stock market reflects the economy, but we have included the impact of inflation rate as 4% in our computation. By sticking with this assumption we compute the fair value for Rosario. The fair value for the company is $95.78 which is quite higher than the companys offered value. Question no. 6 Which course of action should Este adopt? In preparing your recommendation, use the FRICTO framework to identify the trade-offs between the two alternatives. (FRICTO stands for flexibility, risk, income, control, timing, and other.) From our analysis we have come to find that , the offer (IPO) price of $9 per share of Rosario stock would much lesser than its fair (intrinsic) price of $95.77. Similarly, Rosario's intrinsic equity value will be negative by $29.19 per share if the new debt with warrants is used as a financing option. So we have decided to g for IPO rather than short notes with warrants. The FRICTO analysis is as follows:
y

Flexibility: When warrant is used the it may use up the firms debt capacity, thus precluding debt as a financing option in future years to meet the firms anticipated future financing requirements. . Sometimes the need for additional capital in the future is for unforeseen reasons, such as a sudden investment opportunity or a financial crisis due to a severe economic downturn. So issuing warrants does not provide flexibility to the company. But issuance of IPO would be more flexible. The EPS produced are forecasted to be higher and the firm would maintain most of its flexibility due to it. By becoming a publicly traded company a business can take advantage of new, larger opportunities and can start working towards incorporation and even worldwide expansion. IPO gives a company fast access to public capital.

Even though public offering can be costly and time consuming, the tradeoffs are very appealing to companies
y

Risk: IPOs are also a relatively low risk for businesses and have the potential for huge gains and for huge opportunities. The more investors wish to invest in a company, the more the company stands to or from IPOs and other stock offerings. The risk associated with debt is less than that associated with equity financing . If one plans on exercising the warrant he must do so before the expiration date. The more time remaining until expiry, the more time for the underlying security to appreciate, which, in turn, will increase the price of the warrant (unless it depreciates).

Income: For the investor, IPOs are attractive mainly because they may be undervalued. Initially, to make IPOs more attractive, many companies will offer their initial public offering at a low rate. This helps to encourage investors, and investors will often buy IPOs, thinking that the new company or the newly public company will be the next big thing with a huge profit margin. As prices grow and demand for the IPOs grows, early investors stand to make a lot of profit -- and very quickly. So IPOs are good sources of income. Because no additional interest is paid, common stock financing always produces higher earnings after taxes than debt. However, debt financing usually (although not always under all conditions) produces higher ROE and EPS. If interest rates increase after Rosario issues the bonds, Rosario would be set in on a fixed lower rate, which means that they would need to pay out less each period to its bondholders. However, the improving economy may also favor the equity option because Rosario will most likely receive more than his asking share price as the stock price increases. Overall, the debt financing option seems better for Rosario Acero.

Control: The forecasted higher EPS also helps the firm not give up its control. Issuance of warrant does not give the warrant holders voting rights whereas that of IPOs gives the shareholders the voting rights. In this case warrants might have better benefit in terms of the managements control over the firm. Timing: As the case describes that the economy of the country has been gaining better heights after the Mexican Peso crash. the stock market had rebounded from the Tequila effect of the Peso crash. The Merval index has risen over the previous three years, suggesting a growing optimism among the equity investors in Argentina .The market of IPO seemed to be rising though the volume is still low comparatively. Under such circumstances issuance of IPO would have better tradeoff than warrants. Further, debt financing might require high interest payments. Moreover, most of the companies issuing debts in South America have been rated below investment grade. Due to this fact too it would not be wise to go for debt financing. Other: Pablo Este himself is concerned about the liquidity of his investments in the firm. He along with the other equity investors feels the need to increase the marketability of Rosarios common stock. Under such circumstances it would be better to go for IPO as well.

Annex 1: Computation of fair price of stock using Equity financing Competitors Levered Beta D/E ratio Tax rate Multiplier Unlevered Beta Avg. Unlevered Beta Real growth Inflation Nominal Growth rate Rosario Unlevered Beta D/E ratio Multiplier Levered Beta Risk free rate Risk Premium Re D/A 0.4549 E/A 0.5451 Cost of equity Cost of debt WACC 0.1216 0.105 0.5078 0.1176 0.105 0.4688 0.1141 0.105 0.4287 0.1110 0.105 0.3876 0.1082 0.105 0.3459 0.1057 0.105 0.4922 0.5312 0.5713 0.6124 0.6541 0.06 4% 0.1024 1998 0.7947 1.0315 1.6808 1.3358 5.7% 4.54% 0.1176 1999 0.7947 0.8827 1.5826 1.2577 5.7% 4.54% 0.1141 2000 0.7947 0.7503 1.4952 1.1883 5.7% 4.54% 0.1110 2001 0.7947 0.6330 1.4178 1.1267 5.7% 4.54% 0.1082 2002 0.7947 0.5289 1.3491 1.0722 5.7% 4.54% 0.1057 AD 1.35 0.7165 0.34 1.4729 0.9165 0.79477 CSA 1.05 1.5529 0.34 2.0249 0.5185 GA 1.00 0.4444 0.34 1.2933 0.7732 VAZ 1.15 0.2797 0.34 1.1845 0.9708

1997 0.7947 1.1984 1.7909 1.42339 5.7% 4.54% 0.1216

0.0978 Average WACC 0.0892

0.0938

0.0903

0.0872

0.0844

0.0819

1997 Free Cash Flow 1.4135 Discounted FCF 1.2977 FCF 2002 Assumed growth rate WACC Value of all future FCFs on 2002 PV of all future FCFs 38.624 6 PV of Rosario on 1996 (end) Rosario's total liabilities in 1996 Value of Rosario's equity in 1996 No. of stock outstanding Fair price per share 1.7787 6% 0.0892 64.503 1

1998 1.2017 1.0129

1999 1.3255 1.0257

2000 1.4620 1.0386

2001 1.6126 1.0518

2002 1.7787 1.0651

45.116 4 22.8

22.316 4 233000 95.778 4

Annex 2: Calculation of fair price per share using debt with warrant financing Peer Firms Levered Beta D/E ratio Tax rate Multiplier Unlevered Beta Avg. Unlevered Beta AD 1.35 0.7165 0.34 1.4729 0.9166 CSA 1.05 1.5529 0.34 2.0249 0.5185 GA 1.00 0.4444 0.34 1.2933 0.7732 0.7948 VAZ 1.15 0.2797 0.34 1.1846 0.9708

Rosario Unlevered Beta D/E ratio

1997 0.7948

1998 0.7948 3.9618

1999 0.7948 3.1901 3.1055 2.4681

2000 2001 0.7948 0.7948 2.5947 2.7125 2.1558 2.1276 2.4042 1.9108

2002 0.7948 1.7556 2.1587 1.7157

4.9788 Multiplier 4.2860 Levered Beta 3.4064 Real growth 0.06 Inflation 4% Nominal Growth 0.1024 rate Risk free rate Risk Premium Re 0.057 0.0454 0.2117 0.057 0.0454 0.1874 0.057 0.0454 0.1691 0.057 0.0454 0.1549 0.057 0.0454 0.1438 0.057 0.0454 0.1349 2.8729 3.6148

D/A 0.1673 E/A 0.8327 Cost of equity 0.2117 Cost of debt 0.1288 WACC 0.1905 Average WACC 0.1479 0.1669 0.1492 0.1359 0.1260 0.1187 0.1293 0.1302 0.1315 0.1336 0.1370 0.1874 0.1691 0.1549 0.1438 0.1349 0.7985 0.7613 0.7218 0.6803 0.6371 0.2015 0.2387 0.2782 0.3197 0.3629

Working notes: 1997 $6.66 47% 1998 $6.39 46% Old Debt 1999 $5.92 44% 0.105 New debt 1999 7.50 56% 0.13 2000 $5.23 41% 2001 $4.29 36% 2002 $3.06 29%

Amount Percentage of total debt Cost Amount Percentage of total debt Cost

1997 7.50 53%

1998 7.50 54%

2000 7.50 59%

2001 7.50 64%

2002 7.50 71%

1997
Free Cash Flow Discounted FCF FCF 2002 Assumed growth rate WACC Value of all future FCFs on 2002 PV of all future FCFs 1.4135 1.2314 1.7787 6% 0.1479 21.4572 9.3804 1.2017 0.9120

1998

1999
1.3255 0.8764

2000
1.4620 0.8421

2001
1.6126 0.8092

2002
1.7787 0.7776

PV of Rosario on 1996 (end) Rosario's total liabilities in 1996 Value of Rosario's equity in 1996 No. of stock outstanding Fair price per share

14.8292
22.8

(7.9708) 273000 (29.1972)

Annex 3: Calculation of Fair price of share under different assumptions Peer Firms
Levered Beta D/E ratio Tax rate Unlevered Beta Avg. Unlevered Beta

AD 1.35
0.7165 0.34

CSA 1.05
1.5529 0.34

GA 1.00
0.4444 0.34

VAZ 1.15
0.2797 0.34

0.916552872 0.518534 0.773196 0.970808 0.794772535

Rosario Unlevered Beta D/E ratio Levered Beta Risk free rate Risk Premium Re

1997 1998 1999 2000 2001 2002 0.794772535 0.794773 0.794773 0.794773 0.794773 0.794773 1.1984 1.0315 0.8827 0.7503 0.6330 0.5289 1.42339176 1.335861 1.257768 0.057 0.0454 0.057 0.0454 0.057 0.0454 1.18836 0.057 0.0454 1.12679 1.072203 0.057 0.0454 0.057 0.0454

0.121621986 0.117648 0.114103 0.110952 0.108156 0.105678

D/A E/A Cost of equity Cost of debt Cost of debt (after tax) WACC Average WACC

0.454876803 0.49224 0.531165 0.571319 0.612386 0.654069 0.545123197 0.50776 0.468835 0.428681 0.387614 0.345931 0.121621986 0.117648 0.114103 0.110952 0.108156 0.105678 0.105 0.105 0.105 0.105 0.105 0.105 0.0693 0.0693 0.0693 0.0693 0.0693 0.0693 0.097821928 0.093849 0.090305 0.087155 0.084361 0.081884 0.089229491

Free Cash Flow Discounted FCF FCF 2002 Assumed growth rate WACC Value of all future FCFs on 2002 PV of all future FCFs

1997 1998 1999 2000 2001 2002 1.413478032 1.201694 1.325469 1.461992 1.612577 1.778673 1.297686157 1.012873 1.025679 1.038646 1.051777 1.065074 1.778672702 0.06 0.089229491 64.50311068 38.62462818

PV of Rosario on 1996 (end) 45.11636282 Rosario's total liabilities in 1996 (end) 22.8 Value of Rosario's equity in 1996 (end) 22.31636282 No. of stock outstanding 233000 Fair price per share 95.77838118
Assumption: FCF after 2002 grows at 6%

Hence, the offer (IPO) price of $9 per share of Rosario stock would be much lesser than its fair (intrinsic) price Real growth rate Inflation Nominal growth rate 6% 4% 0.1024