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Goodrich Case

In: Business and Management

Submitted By novastudent
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Introduction B.F.Goodrich B.F. Goodrich was an outstanding firm specialized in the field of manufacturing tires. It belonged to the top US companies in the tires and polyvinyl industry. Before the 1982 crisis, its Net Income amounted to 110 million dollars. As the table below shows, the 1982 recession led this company into serious problem. Operating Income Net Income 1981 99 110 1982 51 -33 % change -48% -130%

In the early 1980’s, BF Goodrich needed to raise new funds. However, its credit rating had been downgraded to BBB-. The firm needed $50,000,000 to fund its continuing operations and aimed to lend long-term (8-10 years) debt at a fixed rate. Treasury rates were at 10.1 % and BF Goodrich anticipated paying approximately 12% to 12.5%. The firm was not willing to stipulate an agreement with its current bank, in order not to comprise the flexibility of its future choices. Goodrich wanted a fixed rate, but they believed it would have to pay about 13% for a 30-year corporate debenture. Rabobank Rabobank is one of the largest Dutch banks, consisting of more than 1,000 small agricultural banks. The bank was interested in securing floating rate financing on approximately $50,000,000 in the Eurobond market. Considering their AAA rating, Rabobank could issue fixed rate in the Eurobond market for 11% and for a floating rate of LIBOR plus 25 basis points. Without an active swap market it was common for swaps to be arranged between the two counter parties. Rabobank was interested in the deal but feared the credit risk, as Goodrich’s credit rating had recently been downgraded to a BBB- status. A direct swap would therefore expose Rabobank to credit risk. The two finally reached an agreement to use Morgan Guaranty as an intermediary. The following diagram shows all the transactions. Note: all the observed rates are semiannual.

Morgan Guaranty ������������������������������ − ������
10.70% + ������ 10.7%

������������������������������ − ������

B.F. Goodrich

Rabobank

������������������������������ + 0.5%

10.7%

Savings bank

Eurobond Market

Q1. How large must the discount ������ be to make this an attractive deal for Rabobank?
10.7% 10.7%

Morgan Guaranty
������������������������������ − ������

Rabobank

Eurobond Market

As illustrated above, Rabobank pays ������������������������������ − ������ semiannually. Pay Pay Receive Final payment Current market 10.7% ������������������������������ − ������ 10.7% ������������������������������ − ������ ������������������������������ + 1/4 % - 3/8%

To be profitable, the discount must be less than what it would pay by borrowing from the market: 1 3 ������������������������������ − ������ ≤ ������������������������������ + % − % 4 8 1 ������������������������������ − ������ ≤ ������������������������������ − % 8 ������ ≥ ������. ������������������% This means that in order for the swap to be an attractive deal for Rabobank, the discount ������ must be greater than 0.125%. Q2. How large must the annual fee ������ be to make this an attractive deal for Morgan Guaranty? Morgan Guaranty acted as an intermediary between Goodrich and Rabobank. Morgan Guaranty earns ������ semiannually from the swap agreement. At this stage, we assumed no default risk.
10.7% + ������ 10.7%

B.F Goodrich
������������������������������ − ������

Morgan Guaranty
������������������������������ − ������

Rabobank

Pay Pay Receive Receive Final inflow

10.7% ������������������������������ − ������ 10.7% + ������ ������������������������������ − ������ ������

The swap is an attractive deal for Morgan Guaranty if it brings gain. One first answer to the question could be that the swap is always profitable for Morgan, as long as the fee ������ is positive. However, Morgan receives an initial payment of $125,000 from Goodrich, and this must be taken into account.

With ������ being the semi-annual rate, the equivalent rate over 8 years is 1 + ! Morgan, the cash in flow must be positive: $������������������, ������������������ + ������ + ������/������
������������

! !"

− 1. To be profitable for

− ������ $������������, ������������������, ������������������ ≥ ������

������ ≥ − ������. ������������������������������������������. If we are interested in the annual fee, ������, we can use the following equality: ������ 1+ 2 from which we get ������ = 2
!

− 1 = ������,

1 + ������ − 1 . Rearranging the inequality above, we arrive to a similar result: ������ ≥ − ������. ������������������������������������������.

Assume now that the Goodrich’s default probability is greater than 0. Standard & Poor constructed a ratings transition matrix, which indicates one-year ratings migration probabilities based upon bond rating data from the period 1981-2000:
Standard & Poor's rating transition matrix (1 year) AAA AA A BBB BB B CCC Default AAA 93.66 5.83 0.4 0.08 0.03 0 0 0 AA 0.66 91.72 6.94 0.49 0.06 0.09 0.02 0.01 A 0.07 2.25 91.76 5.19 0.49 0.2 0.01 0.04 BBB 0.03 0.25 4.83 89.26 4.44 0.81 0.16 0.22 BB 0.03 0.07 0.44 6.67 83.31 7.47 1.05 0.98 B 0 0.1 0.33 0.46 5.77 84.19 3.87 5.3 CCC 0.16 0 0.31 0.93 2 10.74 63.96 21.94 Default 0 0 0 0 0 0 0 100

According to this table, a BBB-rated bond has 0.22% probability of default by the end of the year. If we want two-year default probabilities, we simply multiply the matrix by itself once to obtain a two-year ratings transition matrix. For three-year default probabilities, we multiply the matrix by itself three times, etc. Therefore we can easily obtain the 8 years transition matrix:
Standard & Poor's rating transition matrix (8 years) AAA AA A BBB BB B CCC Default AAA 59.94 28.04 9.21 2.01 0.44 0.22 0.04 0.09 AA 3.25 53.49 31.96 8.07 1.63 0.94 0.15 0.47 A 0.64 10.52 57.17 22.61 5.15 2.36 0.36 1.25 BBB 0.27 2.94 21.07 48.32 14.95 6.97 1.15 4.37 BB 0.19 1.00 6.52 21.94 31.42 20.66 3.33 15.06 B 0.10 0.64 2.65 6.69 15.68 32.79 5.26 36.32 CCC 0.34 0.38 1.76 4.00 6.96 14.56 4.71 67.43 Default 0.00 0.00 0.00 0.00 0.00 0.00 0.00 100.00

As illustrated above, the Goodrich default probability in 8 years is 4.37, whereas the Rabobank’s default probability is slightly above 0 after 8 years (0.09%). However, we are not going to consider the Rabobank default for two reasons: 1) Its probability is very close to 0; 2) Rabobank pays ������������������������������ − ������ − 10.70% to Morgan, and, as ������ > 0.125%, we assume ������������������������������ < 10.70%. This implies that it’s actually Morgan that is paying fees to Rabobank; therefore Rabobank’s default would not be a bad news for Morgan.

One way to assess the annual fee for Morgan Guaranty could be to take into account the default probability and impose that the expected value of the fees must be greater than 0. Let ������! be the default probability at time ������ of Goodrich, and let ������!,!""#!$ and ������!,!""#!$ be the fees that respectively Goodrich and Rabobank pay at time ������ to Morgan Guaranty. The expected fees that Morgan receives at time ������ are given by: ������ ������������������������! = ������! ×0 + 1 − ������! ������!,!""#!$ + ������!,!""#!$ = 1 − ������! ������!,!""#!$ + ������!,!""#!$ • ������! can be derived from the rating transition matrices by subtracting the default probability up to time ������ − 1 ������!,!!! from the default probability up to time ������ ������!,! . For example, from the tables we know that ������!,! = 0.22% and ������!,! = 0.54%, then ������! = 0.54% − 0.22% = 0.32%. ������!,!""#!$ and ������!,!""#!$ are given by 10.70% + ������ + ������ − ������������������������������ ! ������!,!""#!$ = 1 + − 1 ⋅ 50,000,000 2 ������������������������������ − ������ − 10.70% ! ������!,!""#!$ = 1 + − 1 ⋅ 50,000,000 2 In order for the swap to be a good deal for Morgan Guaranty, the following inequality must hold:
!



125,000 +
!!!

������ ������������������������! ≥ 0.

Thus, 125,000 + 8������!,!""#!$ + ������!,!""#!$

!

1 − ������! ≥ 0.
!!!

Now for simplicity assume ������ = 0.125% and ������������������������������ = 8.75% are constant. From the tables in the excel file,
! !!!

1 − ������! = 7.9544. 1.010375 + !
! !

Then ������!,!""#!$ = −1,032,117.969 and ������!,!""#!$ = finally get:

− 1 50,000,000. Therefore we

������ ≥ 0.143 Using the usual transformation in annual fee ������, we finally arrive to: ������ ≥ ������. ������������������% This result makes sense, as Morgan Guaranty requires from Goodrich a bigger fee because of the default risk.

Q3. How small must the combination of ������ and ������ be to make this an attractive deal for B.F Goodrich? Semi-annual rates:
������������������������������ − ������ ������������������������������ + 0.5%

Morgan Guaranty
10.7% + ������

B.F Goodrich

Savings Bank

Then the interests that Goodrich actually pays are ������ + ������ + 11.20%, as we can see in the following table: Pay Pay Receive Final Payment
!!!!!!.!"% !" !

10.70% + ������ ������������������������������ + 0.5% ������������������������������ − ������ ������ + ������ + 11.20%

Now we proceed similarly to how we did in the previous question. The equivalent rate that Goodrich pays over 8 years is 1 + 1+
!".!" !

− 1, whereas the equivalent rate that Goodrich would have on the market is

%

!"

− 1.

Remembering that at the beginning Goodrich pays a one-time fee of $125,000, in order for the deal to be attractive, the following inequality must hold: $125,000 + ������ + ������ + 11.20% 1+ 2
!"

− 1 $50,000,000 ≤ $50,000,000

12.50% 1+ 2

!"

−1

Doing the computation, we arrive to:
!"

������ ≤ 2

12.50% 1+ 2

!"



1 − 2 − 11.20% − ������ 400

As we want the deal to be profitable for both Goodrich and Morgan, we can use the result found in the previous question, that is ������ ≥ −0.0003128. Substituting it into the above inequality, we finally arrive to the condition on ������: ������ ≤ ������. ������������������������ We can wonder what would be the interval for ������ such that the deal is profitable for all the parties, that are Goodrich, Rabobank and Morgan Guarantee. Joining the result just obtained with the result in the question 1, we deduce that the discount must lay in the following interval: ������. ������������������% ≤ ������ ≤ ������. ������������%.

Q4. Is this an attractive deal for the savings bank? Alternatives 30-year fixed rate residential mortgages Invest in short-term treasury bills Large CDs of commercial banks (Prime Euro-dollars CDs) Floating rate notes of major US banks whose yield were tied to T-bills notes Buy Goodrich floating rate notes with a yield tried to LIBOR Yield 13% (risky asset) T-bills = 8.07% 8.50% T-bills + 1% = 9.07% LIBOR + 0.5% = 9.25%

The information above is based on T-bill and LIBOR rates dated in 1983. As can be concluded from the alternative options illustrated above, the deal has been attractive for the savings bank. Behind this statement there’s the assumption that the LIBOR and the T-bill interest rate will remain equal or close to the level of the agreement day. In order to deeply verify if the fifth option was persistently the best choice, among this set of opportunities, we took in consideration the trend of the two floating interest rates. As the table illustrates, the floor of the T-bills seems to be around the 8%, whereas the LIBOR rate floor is around 10%. Since the T-bills always have a lower yield, we can exclude this alternative as potentially attractive for the saving bank. In addition, we can easily verify that they both followed the same trend, with the LIBOR always greater than the T-bill rate. The level of the rates on the agreement day is the lowest ever reached by both. Buying Goodrich floating rate notes would have made sense even in the past. Of course, this analysis is myopic and not enough to justify the belief of the saving banks in considering this level of rates reliable for the contract period. However, it gives a reasonable point to support this decision.…...

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...Assignment Questions for Harvard Cases 3. Hilton Manufacturing Company In Exhibit 3 of the case, change the description for estimating variable portion of "Compensation" and use 5% of direct labor cost rather than 5% of direct labor and indirect labor cost as indicated in that Exhibit 3. Again, DO NOT USE 5% of DL and IDL costs. A product cost is itself a product of a cost accounting system. To use product cost information in decision making, a manager must understand the nature of the cost measurement system that has been used to estimate a product cost and be able to evaluate whether or not the product cost at hand is appropriate for the decision which is about to be made. A second objective is to provide practice in considering whether or not assumptions about cost behavior are critical to decisions and to expand the notion of contribution beyond the simple idea of price minus variable cost per unit. A third objective introduces the concept of breakeven analysis, not by focusing on the point where no profit is earned but rather as a tool to consider whether or not one of two price points might be preferred. Finally, the last assignment question invites you to consider factors that lead to profitability. You begin your analysis by focusing on two issues raised in the assigned questions. The first is whether the decision not to drop Product 103 as of January 1, 2004 was wise. In addition, you are asked to analyze what would have been the impact on......

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...A few tips from Bain & Company: • • • • • Don't get thrown by the interviewer's questions. The interviewer is your ally and uses questions to get a better understanding of your thought process--not to stump you. Be concise. If asked for the top two issues, confine your response to two items. Provide logical back-up for your answers. Be sure to explain what case facts led you to a conclusion, and how you reasoned from those facts to your conclusion. Don't be afraid to ask clarifying questions. If you don't understand the case facts, it will be tough to ace the interview. Relax and have fun. You should learn a lot about yourself through the case interview process. A few tips from Mercer Management: • • • • There is no "right" answer. We are not looking for a specific answer. We are trying to gain some insight on your thought process. Ask questions. We do not expect you to know anything about the industry presented in your case. We do expect you to ask good questions. Think out loud. The point of the case interview is to understand how you think. Structure your answer. We're looking for an organized pattern of thought to attack the problem, not a disparate set of ideas. Help us see how you order your thoughts and ideas, moving from one to the next in order to address the question. While use of a framework may be helpful in this area, be careful if you use one. We want to understand your thought process, not see that you've memorized someone else's framework. (And never use a......

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...Case Analysis - FPL Energy FPL Energy is one of the nation’s leading independent generators of electricity. Dedicated to generating clean energy, 80 % of its capacity is fueled by clean and renewable resources. The United States is the nation with the largest generator of wind energy, and it operates the two largest solar fields in the world. FPL Group, with annual revenues of more than $8 billion, is one of the nation's largest providers of electricity-related services. Its principal subsidiary, Florida Power & Light Company, serves approximately 3.9 million customer accounts in Florida. FPL Energy, LLC, and FPL Group energy-generating subsidiary, is a leader in producing electricity from clean and renewable fuels. 2. Historical Overview FPL Group is a far different company today than the one Jim Broadhead joined in January of 1989 when he became president and chief executive officer. FPL Group was then engaged in a number of businesses unrelated to its core electric skills, including insurance and financial services, real estate, cable television, and agriculture. The company's principal subsidiary, Florida Power and Light, was considered a well-managed utility with an emphasis on quality. However, the utility's spiraling costs had resulted in electric rates among the highest in the Southeast. Today, FPL Group is nationally known as a high quality, efficient, and customer-driven organization focused on energy-related products and services. With a......

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