MEMO

To: Hult Corporate Finance Students

NOTE: This is a memo that I wrote after last year's discussions of the case, and it mentions estimates of key variables, like the growth rate, that that students made in class during those discussions.

Re: Using levered Beta to explain how B/E Aerospace stock could have been an interesting speculation

As of 9/2004 BE Aerospace had 37.1 million shares of stock outstanding. The stock was trading around $9 a share. The company was then able to sell 18.4 million new shares, raising $156 million. The new issue of stock was done at the price to investors of around $9 a share. We focused on what the new investors must have been thinking. Obviously they did not buy the newly issued shares thinking they were a safe investment. They bought the 18.4 million new shares in hopes that the stock price would rise, perhaps to $15, $18, $20 a share or even higher in two years. We used the Hamada formula relating levered Beta to unlevered Beta, the CAPM, and the formula for the price of a stock to show how the stock could rise enough to make the purchase of the newly issued shares a worthwhile speculation. The steps to this calculation are as follows. We know that the Beta before the new issuance of stock was 1.95. That is the levered Beta. So lets use the Hamada formula to figure out what the unlevered beta was as of 9/2004. For the Hamada formula we use the market value of the equity, which was approximately 37.1 million shares * $9 per share = $333.9 million. We use the debt figure from the case of $835 million and the tax rate of 40%.

BL = BU (1 + 835*(1-0.4)/333.9) 1.95 = 0.78*(1+835*(0.6)/333.9)

So the unlevered Beta is 0.78. This is high because the nature of the business is volatile. During class discussions several students suggested that the unlevered Beta might have been even higher, for example 1.05 or 1.1.

The next calculation to do is to compute what would be the levered Beta if the company used the $156 million from the sale of stock to pay debt, and then made profit of $28 million and used that to pay debt, and then made profit of $56 million and used that to pay debt. In that case the debt after two years would be $835 - $156 -$28 -$56 = $595 million. Next we computed what would be the earnings per share if the company earned $56 million. Shares outstanding at that time would be 37.1 million + 18.4 million = 55.5 million. So earnings per share would be $56 million/55.5 million = $1.01 The formula for the stock price is Stock price = Earnings per share/ (KE g) KE is the cost of equity and it comes from the CAPM, which is KE = rf +Beta*(rm-rf) We used 6% for the rf and 8% for the market risk premium rm-rf. The Beta to use is the new levered Beta, which would be BL = 0.78*(1+595*1-0.4)/E)

E is the market value of the equity. I used $9 * 55.5 million shares = $499.5 million. I also used $10 a share or $555 million. I used two different prices for the common stock because if the company did what investors were expecting its stock price would rise and could have reached $10 a share on its way toward $18 a share or $20 a share. Using $499.5 as the market value of the equity, we compute the new levered Beta, which is BL = 0.78*(1+595*0.6/499.5) = 1.34 Now with the new levered Beta we can compute the new cost of equity. That is KE = rf +Beta*(rm-rf) = 4% + 1.34*7% = 13% In class we used 21.6% as the beginning cost of equity, and then considered the scenario in which the cost of equity declines to 18%. Now using the KE in the formula for the new price of the stock Stock price = Earnings per share/ (KE g) = 1.01/(13%-g) We do not observe g so we have to make an assumption about what value of g investors will consider realistic. The case mentions 10% as a possible value of g. We considered a few other values for g. For the two years after September 2004, g might be higher than 10%, but students pointed out that g is supposed to be a perpetual growth rate. One student argued that after the first twelve months, the g should be 8%. Using Ke of 13% and g of 8% and 10%, we and putting these numbers into the stock price formula we arrive at possible stock prices of $20.2, and $33.66. What these calculations show is that the investors who bought the newly issued shares of BE Aerospace would have earned a good speculative profit on the shares IF the company uses the proceeds for the sale of shares to pay debt and IF it then earns profits of $28 million during the next twelve months and profits of $56 million in the twelve months after that and IF it then applies the profits to pay debt. .

The formulas show that the company could have commenced a virtuous circle process and the stock price could have risen to the $20 level quite quickly. The reason is that the market value of the equity is the usual input to the Hamada formula. So consider what the levered Beta would be if the price of the stock reached $12. In that case the market value of the equity would be $666 million. The levered Beta would then be lower than 1.34. It would be 1.2. In that case the cost of equity would be KE = rf + B*(rm-rf) = 4%+1.2*7% = 12.4% Using 12.4% as the KE and using 8% and 10% for g we compute that the stock price would rise to $22.95, or $42. Now we see the range of outcomes for the stock price after two years if the company does what it should. We can see that investors would have to be VERY optimistic to use 10% for g, so we can discard that and focus only on values of g of 8% and a lower figure, for example 6%. In those scenarios the stock would rise to some price between $14.4 and $22.95 in two years. The people who buy the newly issued shares at $9 each and keep them for two years would make a high annual rate of return on their investment, between these two figures $9*(1+r)^2 = $14.4 r= 26.5%

$9*(1+r)^2 = $22.95

r = 59.7%

These results show what investors were hoping would happen. They would be richly rewarded for taking the risk of buying BE Aerospace shares. During class discussions I emphasized that the companys previous decisions had never been prudent or intelligent so I doubted that the stock would go up. Instead I was worried that it would fall to $0. That is why I felt that the shareholders best hope was that BE Aerospace would be acquired by one of its competitors. That possibility is another reason why investors were willing to buy the 18.4 million shares that the company sold in October 2004. After the sale of stock the company is more attractive to a potential acquirer because it has enough cash to survive if there is another unexpected event. That cash might be appealing to one

of the companys competitors so the company might have attracted a takeover offer and the offer would be at a higher price than $9.

The scenarios in which B/E stock price rises also show that B/Es competitors have to act fast. They have to buy B/E while it is still cheap. If they do not act, and B/E stock rises, B/E might acquire one of its competitors. The prey could become the predator. What happened in real life is that the stock did rise to about $20 per share in two years. The moral of the story is that buying risky stocks in the U.S. sometimes works very well. Investors who buy risky stocks in the have to be able to assess risk, and to tolerate volatility, but they are often rewarded with high returns. Let's make sure we understand what the institutional rules and practices need to be for good results to happen. Let's also make sure we all understand why in most other countries buying risky shares is NOT a smart thing to do.