Prada’s Hong Kong Ipo

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Case Study: Prada’s Hong Kong IPO

Students exam numbers: 85730, 80964, 86510, 90316

Part A: Problem set - Valuation, spin offs and debs

Question 1

(a)  What is the value of the total firm?  What is the value of equity and debt?

Assumptions:

• Cash is assumed to be excess cash.
• In the calculation: Interest on debt is paid by Parriott A, which is riskless and will always receive the tax shield. In reality, the combined corporate will always have a minimum EBIT of $60mil and receive the full tax shield.
• PP&E have a salvage value of $0 for liquidation.
• Total firm value is calculated under liquidation instead of going-concern.

The total value of the firm in liquidation is the sum of present value of free cash flows (i.e. EV of $42.5M), salvage value (assumed $0), NWC ($5M), which is $47.5M. Total value including $10M in cash is $57.5M. The amount owing to debt holders is $40M principal and $4 Interest, $44M in total, while equity holders would receive the residual $3.5M in firm value, as well as $10M in excess cash.

(b) The CFO is thinking of breaking the company in two by spinning off Division B into a separate firm, Parriott B.  The remaining part would be called Parriott A.   Describe qualitatively what the trade-off theory of capital structure would suggest is the optimal capital structure for the two new firms, respectively.

Parriott A’s capital structure:

Since Parriott A is completely riskless, trade-off theory stipulates that the benefit of a large tax shield through heavy leverage would be most beneficial for the firm. Until leverage reaches a level where EBT is below $0 due to heavy interest payments, the riskless firm is not at risk of financial distress. Thus, Parriott A can benefit from a risky capital structure of high leverage (i.e. financial risk) due to its low business risk.

Parriott B’s capital structure:

Parriott B is equally likely to incur a positive or negative EBIT. The benefit of tax shields would occur only half the time in the absence of tax-loss carried forward in this case. Meanwhile, the cost of financial distress begins to offset the benefits as leverage increases.

Direct costs of financial distress includes legal and proceeding fees and fire sale of assets, while indirect costs could include loss of customers/suppliers/employees, inability to raise new funds, and vulnerability to predatory actions of competitors. In addition, agency costs such as debt overhang can make management forego potentially profitable opportunities (as debt holders will incur the benefits), while risk-shifting incentives management to take outsized risks at the expense of the firm’s debt holders.

Thus, since the benefits of tax shield occurs only half the time, while costs of financial distress is elevated by debt and uncertain outcomes, Parriott B should adopt a less risky capital structure (i.e. less leverage, financial risk) to compensate for its risky business.

(c) The CFO suggests structuring the spin-off as follows:

• All of the cash and half of the debt ($20M face value) is allocated to Parriott B, while half of the debt remains with Parriott A. Existing net working capital remains with Parriott A.
• All capex and depreciation remains with Parriott A.
• Existing shareholders of Parriott get one share each in Parriott A and Parriott B for each owned in Parriott.

What is the value of equity for Parriott A? What is the value of debt for Parriott A?

Again assuming liquidation, the EV of Parriot A’s is the sum of FCF in 1-year (i.e. EV, $35mil), salvage value (assumed $0), cash ($0), NWC ($5M); totaling $40mil. Of which, $20M in principal and $2 in interest are due to the debt holders, totaling $22M. The rest would be accrued to equity holders, of $18M.

What is the value of equity for Parriott B? What is the value of debt for Parriott B?

The EV of Parriot A’s is the sum product of its two FCF scenarios in 1-year (i.e. average of $25 and -10 = $7.5M), salvage value (assumed $0), cash ($10M), NWC ($0M); totaling $17.5M. All of the $17.5M would be accrued to debt holders since they have a principal of $20M, and has seniority over equity holders. Thus, debt value = firm value including cash = $17.5M while equity value is zero.

What is the total value of the two firms after the spin-off, and what is the value of this proposal to original shareholders of Parriott?  Describe what drives the difference in valuation (if any) relative to your answer in question a) above.

The total debt and equity value of the two firms is the combined value of Parriott A and B, $40M and $17.5M, which is $57.5M including cash, same as question a). However, compared to the combined firm, the spun-off firm equity holders receive $18M from Parriott A and $0 from Parriott B, while shareholders receive $13.5M if the firm is treated as a whole. Thus, the spin off value to equity holders is $4.5M

The reason behind this is because under the break-up scenario, debt holders absorb the losses in the “bad” scenario by receiving less principal, while equity holders are protected by limited liability, and will not lose beyond their initial investments. Thus, this break up represents a transfer of wealth from debt to equity holders of $4.5M.

Part B: Case - Prada’s Hong Kong IPO

Question 1

Briefly describe Prada’s business and the key factors to succeed in it. Why is Prada going public? Why in Hong Kong? Why now?

Prada is an iconic Italian luxury group engaged in the design, production and distribution of an array of product categories. The core was Leather Goods production – from bags to luggage and accessories. This category formed 50% of sales and was its largest, fastest-growing, and highest-margin segment. Footwear and Ready-to-wear, also core, formed 25% and 24% of sales, respectively. Eyewear and fragrances were licensed out.

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