Pinkerton Assignment 1) a. Pinkerton’s tax benefits of debt are higher or lower? Compared to a average firm, Pinkerton’s tax benefits are way higher, since it is mainly financed by debt. b. Pinkerton’s probability of financial distress is higher or lower? The probability of financial distress of Pinkerton is higher than an average firm, since it has high leverage. Perhaps even bankruptcy. c. Pinkerton’s costs of financial distress if the firm actually finds itself in financial distress are higher or lower? What do you think is the most important cost of financial distress for Pinkerton The cost of financial distress is way higher because they have a higher debt. Plus, they decided to allow Berkley to buy shares and to MHTC the right to purchase up to 5% of the common stock. The most important cost of financial distress is that they are not able to acquire new security firms. They do not have the required funds to invest into positive NPV projects. They are already losing clients due to premium pricing. They also have underinvestment due to the debt overhang. d. The incentive benefits of debt are higher or lower? Higher, because the higher the debt, the higher the incentive benefits of it e. Based on the above, should Pinkerton take on more or less debt relative to an“average” firm? Since Pinkerton get a higher incentive of benefits of debt, it should take more debt than an average firm. f. Do you think Pinkerton has too much or too little debt as of January 1, 1990? Even thought they should have more debt than the average, they have way too much debt. 2. a. Do you think Berkeley is likely to use its warrants? Yes of course, they have the opportunity to buy a share for 0,0007$ while it’s market value is of the shares in 1989 is : 23709000 / 4719569 = 5,0235. (total equity / number of shares ). Plus, as the end of 1989, 152279 warrants were already vested.
b. If Pinkerton does not pay down the Berkeley debt within five years (and does not go ahead with the IPO), what will be the number of shares outstanding as of January 1, 1994? As in 1989, already has 4719569. Berkley are allowed to get 507597 and already vested 152279. They will vest all of them, so (507597-152279 = 355318) In 1994, there will be 4719569 + 355318 = 5,074,887 shares. c. If Berkeley uses its warrants, how does this affect Pinkerton’s other shareholders in qualitative terms? There will be more shares, thus the value of the shares will decrease by a lot. Therefore, other shareholders will lose money if Berkley uses it warrants. 3. a) Calculate Pinkerton’s asset cost of capital. Assume that the beta given for Wackenhut is the firm’s equity beta and that the market risk premium (E(rm) – rf) is 6%. B = 1,3 Rm-rf = 6% Rf = 10,5 % 10,5 + 1,3 ( 6 ) = 18,30% Estimate Pinkerton’s free cash flows between 1990 and 1999. To do this, use the financial assumptions on page 5. Your valuation should also assume that (a) the corporate tax rate is 37%; (b) the growth rates Pinkerton is using are nominal rates (i.e. not inflation adjusted); (c) the valuation date is December 31, 1989. Don’t forget to deduct depreciation and (tax deductible) amortization before you arrive at EBIT. Page 5 and footnote 4 details depreciation, tax deductible amortization and non-tax deductible amortization.
