Financing Policy

Case: Polaroid Corporation, 1996

Ten Years Financial Summary (US$ Millions)

1995 1994 1993 1992 1991 1990 1989 1988 1987Selected Income Statement InformationNet Sales - US $1,019.0 $1,160.3 $1,178.8 $1,145.7 $1,113.6 $1,058.3 $1,091.8 $1,048.3 $1,009.3Net Sales - International 1,217.9 1,152.2 1,066.1 1,006.6 957.0 913.4 812.9 814.6 754.6Net Sales - Total 2,236.9 2,312.5 2,244.9 2,152.3 2,070.6 1,971.7 1,904.7 1,862.9 1,763.9Operating Expenses 2,147.7 2,112.2 2,059.5 1,938.5 1,824.0 1,687.4 1,600.5 1,689.1 1,610.1Profit from Opns. Before Restructuring Exp. 89.2 200.3 185.4 213.8 246.6 284.3 304.2 173.8 153.8Restructuring Expense 247.0 0.0 44.0 0.0 0.0 0.0 40.5 151.9 0.0Interest Expense 52.1 46.6 47.9 58.5 58.4 81.3 86.2 29.0 15.0Net Earnings -140.2 117.2 -51.3 99.0 683.7 151.0 145.0 -22.6 125.2Common Shares, End of Year (000s) 45,533 45,998 46,806 46,668 48,919 50,070 52,110 71,635 61,918Common Shares Repurchased (000s) 1,218 941 0 2,258 1,151 2,040 19,525 0 0Repurchase Outlay ($ millions) $40.2 $30.6 $0.0 $63.4 $30.6 $55.6 $950.6 $0.0 $0.0Common Shares Issued (000s) 753 133 138 7 0 0 0 9,717 0Earnings Per Share -$3.09 $2.49 -$1.10 $2.06 $12.54 $2.20 $1.96 -$0.34 $2.02Dividend Per Share $0.60 $0.60 $0.60 $0.60 $0.60 $0.60 $0.60 $0.60 $0.60

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Ten Years Financial Summary (US$ Millions)

1995 1994 1993 1992 1991 1990 1989 1988 1987Selected Balance Sheet InformationWorking Capital $738.5 $886.8 $833.6 $789.0 $695.3 $609.1 $642.0 $980.0 $652.6Net Property, Plant & Equipment 691.0 747.3 718.2 657.3 549.4 461.0 430.9 433.8 359.6Total Assets 2,261.8 2,316.7 2,212.3 2,008.1 1,889.3 1,701.3 1,776.7 1,957.2 1,599.4Long-Term Debt 526.7 566.0 602.3 637.4 471.8 513.8 602.2 402.3 0.0Redeemable Preferred Stock 0.0 0.0 0.0 0.0 0.0 348.6 321.9 0.0 0.0Common Stockholders' Equity 717.7 864.4 767.3 808.9 772.9 207.7 148.8 1,011.5 1,048.2Addns. to Property Plant and Equip. 167.9 146.7 165.6 201.5 175.8 120.9 94.5 127.0 116.6Depreciation $132.7 $118.2 $100.3 $89.1 $85.5 $87.2 $87.4 $81.9 $75.7Book Value LT Debt/Capital 42.3% 39.6% 44.0% 44.1% 37.9% 48.0% 56.1% 28.5% 0.0%Market Value LT Debt/Capital 19.6% 27.5% 27.8% 30.5% 26.6% 25.3% 28.5% 23.4% 0.0%

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Ten Years Financial Summary (US$ Millions)

1995 1994 1993 1992 1991 1990 1989 1988 1987Selected Valuation Information (at years' ends)Polaroid Stock Price $47.38 $32.50 $33.50 $31.13 $26.63 $23.38 $22.88 $18.38 $11.88S&P 500 Index 615.93 459.27 466.25 435.71 417.09 330.22 353.40 277.72 247.08 Polaroid Average P/E (1) 12.1 13.3 15.6 14.2 12.2 15.6 21.8 NMF 14.7S&P Industrials Average P/E (1) 15.2 15.5 18.4 19.8 19 14.4 12.6 10.8 15.3Polaroid Market/Book Ratio 3.01 1.73 2.04 1.80 1.69 5.63 8.01 1.30 0.70 Polaroid Beta 1.05 1.05 1.15 1.15 1.20 1.25 1.25 1.25 1.20Yield on 30-Year T-Bonds 6.88% 7.37% 6.59% 7.67% 8.14% 8.61% 8.45% 8.96% 8.59%Yield on 90-day T-Bills 5.49% 4.25% 3.00% 3.43% 5.38% 7.50% 8.11% 6.67% 5.78%Total Annual Return on Large Co. Stocks 33.00% 1.30% 9.90% 7.67% 30.55% -3.17% 31.49% 18.81% 5.23%

5

Income Statement: Consolidated Statement of Earnings (in $ Millions)

1995 1994 1995 1994Net Sales United States $1,019.0 $1,160.3 46 50 International 1,217.9 1,152.2 54 50 Total Net Sales 2,236.9 2,312.5 100 100Cost of Goods Sold 1,298.6 1,324.2 58 57Marketing, Research, & Admin. 849.1 788.0 38 34Restructuring & Other. 247.0 0.0 11 0Total Costs 2,394.7 2,122.2 107 92Profit/(Loss) from Operations -157.8 200.3 -7 9Interest Income 8.7 9.7 0 0Other Income -0.2 -2.7 0 0Interest Expense 52.1 46.6 2 2Earnings/(Loss) Before Taxes -201.4 160.7 -9 7Tax Expense -61.2 43.5 -3 2Net Earnings/(Loss) -140.2 117.2 -6 5

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Balance Sheet (in $ Millions)1995 1994 1995 1994

AssetsCurrent Assets Cash and Cash Equivalents $73.3 $143.3 3 6 Short-Term Investments 9.8 85.6 0 4 Receivables, less allowances 550.4 541.0 24 23 Inventories 615.5 577.4 27 25 Prepaid Expenses and Other 208.5 141.4 9 6Total Current Assets 1,457.5 1,488.7 64 64 Gross Property Plant and Equipment 2,164.4 2,043.4 96 88 Less Accumulated Depreciation 1,473.4 1,296.1 65 56Net Property, Plant and Equipment 691.0 747.3 31 32Prepaid Taxes -- non-current 113.3 80.7 5 3Total Assets $2,261.8 $2,316.7 100 100

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Balance Sheet (in $ Millions)1995 1994 1995 1994

Liabilities and Stockholders' EquityCurrent Liabilities Short-Term Debt $160.4 $117.1 7 5 Current Portion of Long-Term Debt 39.7 35.9 2 2 Payables and Acrruals 274.9 275.7 12 12 Compensation & Benefits 197.4 121.4 9 5 Taxes Payable 46.6 51.8 2 2Total Current Liabilities 719.0 601.9 32 26Long-Term Debt 526.7 566.0 23 24Accrued Postretirement Benefits 257.2 247.2 11 11Accrued Postemployment Benefits 41.2 37.2 2 2Total Liabilities 1,544.1 1,452.3 68 63Preferred Stock 0.0 0.0 0 0Common Stockholders' Equity 0 0 Common Stock (1) 75.4 75.4 3 3 Additional Paid-In Capital 401.9 387.2 18 17 Retained Earnings 1,525.8 1,692.1 67 73 Less Treasury Stock, at Cost 1,205.4 1,174.5 53 51 Less Deferred Compensation 80.0 115.8 4 5 Total Common Stockholders Equity 717.7 864.4 32 37Total Liabilities and Stockholders' Equity $2,261.8 $2,316.7 100 1008

Financing

•5‐year $150 million• To be used for general purpose• Set to expire in 1999• 1994‐95 – no borrowing in this line

Working‐capital line of credit

• To support the firm’s foreign currency balance sheet exposure

• End 1994 – borrowings outside US were $160.4 million

• Unused borrowings under these lines of credit were $160 million

International line of credits

• $150 million, 7.25% notes due Jan 15, 1997• Issued at a discount (YTM 7.42%)

• $200 million, 8% notes were due March 15, 1999• Had been issued with a  discount of YTM 8.18%

• Both issues were non‐callable

Notes

• Had been drawn in 1988• To establish PC’s leveraged ESOP• As part of leveraged recapitalization of the firm• Scheduled principal payments were made semiannually through 1997 when a final payment of $37.7 million was due

• Weighted average interest on the loan..,• 1995 – 5.2%• 1994 – 4.4%• 1993 – 3.6%

• Special tax benefits to providers of ESOP loans accounted for the unusually low interest rates

ESOP Loan

• $140 million, 8% convertibles due in 2001• Annual interest rate of 8%• Convertible to common stock at $32.50 per share• Redeemable by the company after Sept 30, 1998, or sooner if the stock prices exceeded $48.75 per share for 20 or 30 consecutive trading days

• All of the debentures were held by Corporate Partners

Convertible subordinated debentures

Optimizing Financing Mix

Approaches

Firm Value

Financial Flexibility

WACC

Constraints• Voting Control• Investment Grade Rating

• OIAOperating Income Approach

• CoCCost of Capital Approach

• APVAdjusted Present Value Approach

• RDReturn Differential Approach

• CAComparable Approach

Value1996 1997 1998 1999 2000

Free Cash Flow 120.8 94.3 99.2 105.1 103.1 Ex. 6WACC 10% 10% 10% 10% 10% AssumedTerminal Growth rate 6% AssumedTerminal Value 2732.15Total Free Cash Flow 120.8 94.3 99.2 105.1 2835.25PV of FCF 110 78 75 72 1,760DCF 2,095Less: Debt 726.8Equity Value 1,368Outstanding Shares 45.5Intrinsic Value per Share 30.06Recent Share Price 47.38Premium of Price vs. Value 37%

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Market is in premium because of..,Betting on beneficial effects of a new CEOSubstantial improvements in profit marginsNotable success in emerging marketsPossibility on new products

Gets an opportunity to sell overvalued stocks

AAA AA A BBB BB BWACC (Market Weights) - Hudson 9.60% 9.41% 9.28% 9.08% 9.67% 10.13%WACC (Market Weights) - CAPM 10.58% 10.43% 10.30% 10.14% 10.11% 10.24%DCF - Hudson 2,322 2,448 2,540 2,705 2,278 2,030DCF - CAPM 1,837 1,896 1,952 2,025 2,040 1,979

Ex. 6

Without Taxes With Taxes

Value of the Firm VL = VU VL = VU + tD

WACC rWACC =  rWACC =  1Cost of Equity 1

Firm Value

Firm Value = (47.38*75.4)+(726.8*40%) – Financial Distress Cost

Adjusted PV

Firm Value

Price of Underlying Asset Firm Value ($MM) 4299.252Exercise price Face value of debt ($MM) 726.8Volatility Volatility of opertaing income or share price 34.79%Life of option Term of Debt 3.62Risk free rate Should be contemporaneous with the life of option (~5 years) 6%Put Option Value Using BSM 3627.579

ValuingPutOption

Firm Value = (47.38*75.4)+(726.8*40%) – 3627.579 = 235.6 

Adjusted PV

AAA AA A BBB BB BCost of Debt (pre-tax) 6.70% 6.90% 7.00% 7.40% 9.00% 10.60% Ex. 11Cost of Equity 10.25% 10.30% 10.40% 10.50% 11.75% 13.00% Ex. 11Hudson Guaranty's Estimates of Equity CostsCost of Debt (after tax of 40%) 4.02% 4.14% 4.20% 4.44% 5.40% 6.36% EstimatedCost of Equity 10.25% 10.30% 10.40% 10.50% 11.75% 13.00% Ex. 11Market/Book Ratio 3 3 3 3 3 3 Ex. 1Debt/Capital (Book) 25.90% 33.60% 39.70% 47.80% 59.40% 69.50% Ex. 9Debt/Capital (Market) 10% 14% 18% 23% 33% 43% EstimatedWeight of Debt 10% 14% 18% 23% 33% 43%Weight of Equity 90% 86% 82% 77% 67% 57%WACC (Market Weights) 9.60% 9.41% 9.28% 9.08% 9.67% 10.13% EstimatedWACC (Book Weights) 8.64% 8.23% 7.94% 7.60% 7.98% 8.39% Estimated28

WACCCost of Capital

WACCAAA AA A BBB BB B

CAPM and Levered BetasCost of Debt (pre-tax) 6.70% 6.90% 7.00% 7.40% 9.00% 10.60% Ex. 11Current Levered Beta 1.05Debt/Equity (Market) 11.65% 16.87% 21.95% 30.52% 48.77% 75.96%Recent Debt/Capital (Market) ratio 24% 24% 24% 24% 24% 24%Recent Debt/Equity (Market) ratio 32% 32% 32% 32% 32% 32%Tax rate 40% 40% 40% 40% 40% 40%Unlevered Beta 0.88 0.88 0.88 0.88 0.88 0.88Relevered Beta 0.94 0.97 1.00 1.04 1.14 1.29Cost of Equity (Rf = 6.24%, EMRP = 5.4%) 11.34% 11.49% 11.63% 11.88% 12.40% 13.18%Cost of Debt (after 40% tax) 4.02% 4.14% 4.20% 4.44% 5.40% 6.36%Market/Book Ratio 3 3 3 3 3 3Debt/Capital(Book) 25.90% 33.60% 39.70% 47.80% 59.40% 69.50%Debt/Capital(Market) 10% 14% 18% 23% 33% 43%WACC (Market Weights) 10.58% 10.43% 10.30% 10.14% 10.11% 10.24%WACC (Book Weights) 9.44% 9.02% 8.68% 8.32% 8.24% 8.44%10-year Treasury Bond Rate 6.24% 6.24% 6.24% 6.24% 6.24% 6.24%Implied rate of beta for varios ratings 0.74 0.75 0.77 0.79 1.02 1.25 eg. (10.25%-6

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Cost of Capital

Cost of Equity

9.00%9.50%

10.00%10.50%11.00%11.50%12.00%12.50%13.00%13.50%

AAA AA A BBB BB B

Rating Category

Cos

tofE

quity

CAPM

Hudson

WACC

9.00%9.20%9.40%9.60%9.80%

10.00%10.20%10.40%10.60%10.80%

A AA A A AB BB B B

Rating Category

Cos

tofC

apita

l

CAPM -based WACCHudson's WACCs

Cost of Capital

A (20%) B (60%)

Risk for Lenders

Low* High

Owners Risk Low* High

Credit Rating High* Low

Financial Flexibility

High* Low

WACC ? ?

A B

WACC Financial Distress

Signaling Effects

Incentive Effects

Event Clientele Effects

Cost of Capital

ROE vs. Cost of Equity

Return Differential

1996 1997 1998 1999 2000PBIT 187.53104 232.5934 258.9463 274.1831 293.0259Total Capital 1796.8 1877.8 1974.6 2080.5 2197.8

AAA 25.90% 465 486 511 539 569AA 33.60% 604 631 663 699 738A 39.70% 713 745 784 826 873BBB 47.80% 859 898 944 994 1051BB 59.40% 1067 1115 1173 1236 1305B 69.50% 1249 1305 1372 1446 1527

AAA 6.70% 31 33 34 36 38AA 6.90% 42 44 46 48 51A 7% 50 52 55 58 61BBB 7.40% 64 66 70 74 78BB 9% 96 100 106 111 117B 10.60% 132 138 145 153 162AAA 156 200 225 238 255AA 146 189 213 226 242A 138 180 204 216 232BBB 124 166 189 201 215BB 91 132 153 163 176B 55 94 113 121 131

AAA 11.74% 14.37% 15.36% 15.44% 15.65%AA 12.23% 15.16% 16.26% 16.36% 16.59%A 12.70% 15.93% 17.14% 17.25% 17.50%BBB 13.22% 16.95% 18.35% 18.47% 18.77%BB 12.54% 17.34% 19.13% 19.29% 19.67%B 10.07% 16.46% 18.84% 19.05% 19.56%

AAA 11.34% 0.40% 3.03% 4.02% 4.10% 4.31%AA 11.49% 0.74% 3.67% 4.77% 4.87% 5.10%A 11.63% 1.07% 4.30% 5.50% 5.61% 5.87%BBB 11.88% 1.34% 5.07% 6.47% 6.59% 6.89%BB 12.40% 0.14% 4.94% 6.73% 6.89% 7.27%B 13.18% -3.11% 3.28% 5.66% 5.88% 6.38%

ROE

ROECost of Equity

% Spread

Debt

Debt / Capital

Cost of Debt

Interest Cost

PAT@40% Tax Rate

Comparable Approach

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BBB / Baa3

AAA AA A BBB BB B Required Ratios for Rating CategoryPretax interest coverage (x) 13.50 9.67 5.76 3.94 2.14 1.17 Ex. 9EBITDA Interest coverage (x) 17.08 12.80 8.18 6.00 3.49 2.16 Ex. 9Funds from operations/total debt (%) 98% 69% 46% 33% 18% 13% Ex. 9Free operating cash flow/total debt (%) 60% 27% 21% 7% 1% -1% Ex. 9Pretax return on permanent capital (%) 29% 21% 19% 14% 12% 9% Ex. 9Operating income/sales (%) 23% 18% 16% 14% 14% 12% Ex. 9Long-term debt/capital (%) 13% 21% 32% 43% 56% 66% Ex. 9Total debt/capitalization incl. short-term debt (%) 26% 34% 40% 48% 59% 70% Ex. 9Market/Book value of equity ratio 3 3 3 3 3 3 Ex. 1Market Value Debt/Capital 10% 14% 18% 23% 33% 43% Estimated

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Financial Flexibility

AAA AA A BBB BB B Estimate of Unused Debt CapacityLong Term Debt 527 527 527 527 527 527 Ex. 4Short Term Debt 160 160 160 160 160 160 Ex. 4Current Maturities of Long Term Debt 40 40 40 40 40 40 Ex. 4Total book value of Debt 727 727 727 727 727 727Market Value of Equity 2,158 2,158 2,158 2,158 2,158 2,158 $47.38*45.Enterprise Value 2,885 2,885 2,885 2,885 2,885 2,885Maximum Debt Implied by Rating 301 416 519 675 946 1245 EstimatedUnused Debt Capacity at Current Rating -426 -310 -208 -52 219 518 EstimatedUnused Debt Capacity until Investment Grade Rating is Lost (at BB) 645 529 427 271 0 -300 Estimated37

Financial Flexibility

AAA AA A BBB BB B Estimate of Interest CoveragePretax Cost of Debt 6.73% 6.87% 7.04% 7.40% 9.10% 10.52%

Interest Expense 20 29 37 50 86 131

Normalized 5-year EBIT 244.24 244.24 244.24 244.24 244.24 244.24Downside EBIT (2 Sigma) 150 150 150 150 150 150Coverage ratio - Normalized EBIT 12 9 7 5 3 2Coverage ratio - Downside EBIT 7 5 4 3 2 1

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If wanted to maintain financial reserves at $150 million, then PC cannot borrow much more than it is borrowing now (727 million)

Financial Flexibility

Is Recapitalization a Good Idea?

ESOP

Recapitalization

Repurchase

Long-Term Debt

Common Stockholders'

EquityCurrent BV D/C

BV D/C if $300 Million for Expansion

BV D/C if $300 Million for

RecapitalizationDifference in BV D/C

1995 526.7 717.7 42.33% 53.53% 87.54% 34.01%1994 566 864.4 39.57% 50.05% 76.61% 26.56%1993 602.3 767.3 43.98% 54.04% 84.36% 30.32%1992 637.4 808.9 44.07% 53.68% 81.78% 28.10%1991 471.8 772.9 37.90% 49.96% 81.70% 31.73%1990 513.8 207.7 48.01% 79.67% 193.07% 113.41%1989 602.2 148.8 56.13% 85.84% 200.04% 114.20%1988 402.3 1011.5 28.46% 40.98% 63.05% 22.08%1987 0 1048.2 0.00% 22.25% 40.10% 17.84%1986 0 960.1 0.00% 23.81% 45.45% 21.64%

Run out of profitable and internal investment 

opportunitiesUndervalued Shares

Higher Perception on Manager Confidence of 

Performance

Commitment on the part of insiders not to divert the resources of the firm to other uses