Finance Case Study

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L. S. E. ), M. B. A. COURSE: MBA-680-50-SUIII12 Corporate Financial Theory SEMESTER: Summer Session III Case Study The Many Different Kinds of Debt (solutions) Konstantinos Kanellopoulos 22nd August 2012 CASE STUDY ON The many different kinds of debt It was one of Morse’s most puzzling cases. That morning Rupert Thorndike, the autocratic CEO of Thorndike Oil, was found dead in a pool of blood on his bedroom floor. He had been shot through the head, but the door and windows were bolted on the inside and there was no sign of the murder weapon. Morse looked in vain for clues in Thorndike’s office.

He had to take another tack. He decided to investigate the financial circumstances surrounding Thorndike’s demise. The company’s capital structure was as follows: • 5% debentures: $250 million face value. The bonds matured in 10 years and offered a yield of 12%. • Stock: 30 million shares, which closed at $9 a share the day before the murder. Yesterday Thorndike had flatly rejected an offer by T. Spoone Dickens to buy all of the common stock for $10 a share. With Thorndike out of the way, it appeared that Dickens’s offer would be accepted, mush to the profit of Thorndike Oil’s other shareholders[1].

Thorndike’s two nieces, Doris and Patsy, and his nephew John all had substantial investments in Thorndike Oil and had bitterly disagreed with Thorndike’s dismissal of Dickens’s offer. Their stakes are shown in the following table: | |5% Debentures (Face Value) |Shares of Stock | |Doris |$4 million |1. 2 million | |John |0 |0. | |Patsy |0 |1. 5 | All debt issued by Thorndike Oil would be paid off at face value if Dickens’s offer went through. Morse kept coming back to the problem of motive. Which niece or nephew, he wondered stood to gain most by eliminating Thorndike and allowing Dickens’s offer to succeed? Help Morse solve the case. Which of Thorndike’s relatives stood to gain most from his death? Solutions THE SHOCKING DEMISE OF MR. THORNDIKE

Minicase solution, Chapter 25 Principles of Corporate Finance, 9th Edition R. A. Brealey, S. C. Myers and F. Allen After the corpse was removed, police inspectors came to dust the bedroom for fingerprints. Morse knew they would find nothing. He walked down the marble staircase of Rupert Thorndike’s mansion and into the paneled library. He sat at a table in front of the fireplace, scarcely noticing the painting over it, Monet’s portrait of the legendary John D. Thorndike at Giverny. He turned on his laptop computer. Thorndike Oil had three classes of securities outstanding: $250 million of ebentures (face value), 30 million shares, and an issue of subordinated convertible notes. Morse had to calculate the change in the value of each security now that Thorndike was gone, and given the now near-certain acquisition of Thorndike Oil by T. Spoone Dickens. Table 1 reports Morse’s results. The notes summarize his reasoning. With Table 1 in hand, it was easy to calculate the increases in value due to the murder and resulting acquisition. Debt increased by 39. 5% of face value. Common stock increased by $1. 00 per share, and each convertible note increased from 103. 5% to 110% of face value (from $1039. 50 to $1100 per bond). Morse summed the gains to Doris, John and Patsy (see Table 2). Then he reached for his cell phone and dialed Chief Inspector Spillane. Thorndike Oil Table 1 Values of Thorndike Oil Securities Before and After the Murder | |Before |After | |Debt |$151. 25 million, |$250 million | | |60. % of face value |100% of face value | |Equity |$270 million, |$300 million, | | |$9 per share |$10 per share | |Convertible notes |103. 95% of |110% of | | |face value |face value |

Notes 1. Debt, before: PV at 12% of the 5% coupon for 10 years, plus repayment of face value (100%) at year 10, is 60. 5% of the $250 million face value, or $151. 25 million. Debt, after: essentially risk-free. The debt will be repaid in short order and should trade very close to face value. The gain in market value is 1 - . 605 = . 395, or 39. 5% of face value. 2. Shares: Share price increases from $9. 00 to $10. 00. 3. Convertible notes: Conversion value before is 110 shares at $9 per share = $990 per $1,000 note. The bonds were trading at 5% over conversion value, or 1. 05? 90 = $1,039. 50. Note holders will convert prior to the takeover, receiving 110? 10 = $1,100. (If they don’t convert, they get only $1,000. ) In other words, the notes increase by 110 – 103. 95 = 6. 05% of face value. Thorndike Oil Table 2 Who Gained Most? (Figures in millions) | |Doris |John |Patsy | | | | | | |Debt |$1. 8 |0 |0 | | |(. 395? 4) | | | | | | | | |Stock |$1. 2 |$0. 5 |$1. | | |(1. 00 ? 1. 2) |(1. 00 ? .5) |(1. 00 ? 1. 5) | | | | | | |Convertible notes |0 |$0. 3025 |$0. 1815 | | | |(. 0605 ? 5) |(. 0605 ? ) | | |___________ |___________ |_________ | |Total |$2. 78 |$0. 8025 |$1. 6815 | ----------------------- [1] Rupert Thorndike’s shares would go to a charitable foundation formed to advance the study of financial engineering and its crucial role in world peace and progress. The managers of the foundation’s endowment were not expected to oppose the takeover.