Corporate Finance Essay

Introduction In 2001, the Tulsa, Oklahoma, Williams Company was in financial distress. The primarily energy-industry company was struggling with a shrinking energy trading market, which was marked by distressed entities such as Enron’s broadband unit and Global Crossing. Williams also suffered internally with a floundering telecommunications division and a plummeting stock price. These issues led credit rating agencies Moody’s and Standard & Poor’s to downgrade the credit rating of Williams’ bonds to the level of non-investment-grade junk bonds. Amidst all of this uncertainty, the company on January 21, 2002, announced a new CEO, Steven J. Malcolm. Malcolm realized one of the most important functions for Williams moving forward would be raising capital. Malcolm’s four-pronged plan to achieve this goal involved selling assets, reaching a resolution for its energy and trading book, managing and monitoring cash and businesses and â€Å"right-sizing† Williams to reflect the new scope of operations. However, Williams had a substantial amount of short-term and long-term debt maturing in the second half of 2002. In addition, its credit and commercial paper facilities needed to be renewed about the same time. With approximately $450 million dollars of cash on hand and only one undrawn revolving credit facility, Williams sought external financing to help meet its current cash flow needs. One group of investors led by Warren Buffett’s Berkshire Hathaway along with Lehman Brothers offered Williams a solution with a one-year $900 million loan. Under the terms of the agreement, each lender would loan $450 million to Williams Production RMT, a Williams subsidiary, whose major assets included natural gas properties in the Rocky Mountains. In addition to the repayment of the principal in one year, Williams would pay 5.8 percent interest quarterly and an additional 14 percent of the principal at maturity plus a â€Å"deferred setup fee.† The deferred setup fee would be equivalent to the greater of 15 percent of the principal or 21 percent of the purchase price less RMT’s indebtedness. This would be influenced by any further asset liquidation by RMT. The loan, guaranteed by Williams Company as well as certain subsidiaries, also contained several covenants that Williams must meet to avoid breach of contract. The positive covenants included maintaining an interest coverage ratio of greater than 1.5 to 1 and maintaining a fixed charge coverage ratio of at least 1.15 to 1. Negative covenants limited restrictive payments (including redemption of capital stock) and capital expenditures in excess of $300 million. Thorough evaluation of the terms and lending scenario reveals this loan would create a beneficial scenario not just for the lenders, but for the borrower as well. For Williams, the loan provided temporary relief from multiple short-term debt security maturations and enhanced the company’s ability to secure a credit facility of $700 million. This would likely be followed by favorable market reactions in the form of increased stock price as a result of decreased uncertainty of future cash flows. Also, any Buffett investments in Williams would signal a strong endorsement of the company’s future prospects, likely leading to increases in Williams’ stock price. Likewise, for Berkshire Hathaway and Lehman Brothers, this deal should supply high returns on investment. Assuming the loan would be held to maturity, the lenders would divide returns of approximately 34% on this loan. Given that Williams guaranteed the loan, backing it with asset and capital stock, such returns on this risk would be a huge win for both lenders. Although the risk-free rate would be necessary to determine the exact net present value of the investment opportunity facing Berkshire Hathaway and Lehman Brothers, sufficient information is available to find the project’s internal rate of return. The IRR for this agreement ranges between 11.87% and 13.01%. The return on investment (ROI) for this particular agreement ranges between 52% and 58%. In either case, the numbers range because of provision (c) listed in the case’s Exhibit 1. The â€Å"deferred setup fee† fluctuates depending on potential sales of RMT’s assets. Terms of the proposed financing Guarantees Those involved in the lending process establish financing terms to protect the positions of all parties. The debt guarantee in Williams’ proposed financing, for example, provided insurance for the repayment of debt. Williams would essentially act as a co-signer for Williams Production RMT’s obligations to Berkshire Hathaway and Lehman Brothers. Per the terms, Williams would have to agree to make payments in place of Williams Production RMT if any of the payments were late or not paid. Using a guarantor would allow Williams Production RMT access to a loan at a lower interest rate than if Williams had not secured the loan. The logic behind this is that two individuals or entities promising to pay back the debt means there is lessened risk for overall default. That means Berkshire and Lehman may be willing to accept a lower interest rate in return for less risk of loss. It is quite possible that Williams Production RMT would not have been able to obtain a loan without a gu arantee. Covenants Equity and debt investors have a somewhat adversarial position, though both want a company to succeed. Equity investors want the company to take a certain amount of risk so they have the chance of seeing large returns. Debt investors want a company to be more conservative to protect the issuer and to ensure that the company will repay its debts. Like many other companies, Williams’ top priority, however, is to maximize stockholder wealth. This creates a dilemma in a debt offering. Berkshire Hathaway and Lehman Brothers therefore use debt covenants to limit the amount of risk Williams can take in the hopes that the company’s actions will not endanger loan repayment. Collectively, these covenants outline the rights of the lenders and restrictions upon Williams in regards to the loan. When a company does not live up to its debt covenant, it breaches the contract. In theory, such action would trigger automatic payment to creditors. In reality, however, many companies default because they are not in good financial health and thus cannot pay. Therefore, breach of covenant usually means that the two parties renegotiate the terms of the debt, often calling for higher interest rates or other incentives for the issuer to allow Williams more time to pay. Williams’ financial problem During the first half of 2002, Williams suffered a number of financial difficulties. The company’s total cash flow decreased by 680.22 percent as compared with 2001. During the year, Williams’ only net positive cash inflows came from financing, which netted the company $1.061 billion. In contrast to cash inflows, the company’s outflows totaled $1.589 billion from operations and investing. Overall, the decrease can largely be attributed to the decrease in cash flow from operations, which amounted to a decrease of $2.566 billion. Specific to operations, much to blame is the company’s decrease in working capital of $879 million. To adjust for this decrease in cash flows, the company liquidated a number of assets in 2002. The most valuable included the Kern River and Williams pipelines, which generated immediate cash proceeds of $1.124 billion. The question remained, however, as to how Williams would be able to find a way to pay debts of $2.347 billion within the next year and eventually long-term debts of $11.972 billion. In May 2002, the firm sold another $1.7 billion in assets and announced its intention to sell an $1.5 to $3 billion in assets. Previously, in December 2001, Williams planned to cut its 2002 capital spending by 25 percent or $1 billion to bolster its balance sheet. Williams also issued $1 billion in equity-linked securities called FELINE PACS and decided to cut its dividend by 95 percent. While seemingly drastic measures, the negative total cash flow of $619 million reveals that reducing dividend payments and selling off two major sources of operating income was not sufficient for Williams to dig itself out from under its debt obligations without independent financial assistance. Signs of distress It was clear that Williams was in deep. Though the signs of distress were many, the most noticeable was that the company’s cash flows were insufficient to meet its short-term debt. Unless the company continued to take drastic action, it could have found itself entering into bankruptcy proceedings within the next year. Another concerning sign included that in 2002, Williams’ 95 percent decrease in dividend payments and its more than 90 percent decrease in stock price should have indicated that the firm was struggling. Particularly striking was the fact that dividend disbursements had been increasing for the prior 10 years and that Williams Communications stock closed at a mere $0.01 per share on July 31, 2002. Williams also sent strongly negative signals with its 2002 sales of its Kern River and Williams pipelines. Although these netted the company immediate cash amounting to $1.124 billion, the sale was made at the sacrifice of substantial cash inflows, suggesting this was an act of desperation. Investors weren’t the only ones receiving signs of Williams’ distress. Credit agencies also observed uncertainty in Williams’ future, as indicated by the company’s fluctuating credit ratings. With Williams in July 2002 settling at a B+ Standard & Poor’s long-term credit rating, the company saw resulting increases in bond yields. Whereas Williams had bond yields of approximately 7 percent in December 2001, its yields fell just under 20 percent in July 2002, further complicating its situation. Recommendation Williams’ plight left it with few options for restoring its financial solvency, and most were of limited feasibility. Williams could have issued additional equity at the then current stock price of $2.95 per share, though this would dilute the company’s current share base. In addition, most companies only hold seasoned equity offerings when they believe their stock is overpriced. Considering that Williams’ stock price had fallen by more than 90%, Williams should not consider an equity offering. The company also could have issued more bonds. This option was not feasible, however, due to the company’s credit downgrade.With Standard & Poor’s rating the company a B+ in July 2002, Williams would have to issue many bonds and pay a substantial yield amounting to just under 20 percent per annum. Williams also could have sold assets. Since Williams had already sold close to $3.0 billion in assets, however, selling more could damage the company’s ability to generate operating cash flows. Though Berkshire and Lehman presented an opportunity, most lenders were hesitant to provide Williams capital due to the company’s financial turmoil. This large, 35 percent interest loan appears to have the most favorable terms possible for Williams in its last-ditch effort to save itself. The real winner here, however, would be Berkshire Hathaway and Lehman Brothers, both of whom would glean a lucrative return on their investment, given it is successful. Williams, on the other hand, should agree to the loan only because it has no other feasible options.