Coleco Industries, Inc.

...

---------------------------------------------------------------

Coleco’s strategy

Many of the specific causes of Coleco’s financial distress can be traced to a mismatch between the financial policies of the firm and the degree of risk created by its operating strategy. Indeed, what is remarkable about Coleco’s experience in toy manufacturing is that the company seemed to have no product-marketing strategy at all. The firm lurched from fad to fad, betting that it could play the product life cycle effectively (e.g., Adam computer, Colecovision, and the Cabbage Patch doll line). The search for new products appeared to be completely opportunistic. Because Coleco had no enduring core products, a growth-oriented strategy depended on large successes based on significant investments. Coleco’s active acquisition program (evidenced in purchases of Selchow and Righter, and Tomy Kogyo) was a program of expansion, not diversification. The need for diversity was manifest. Colecovision and Adam, huge temporary successes, ultimately threatened the life of the firm as they wound down. Like a bicycle, Coleco had stability only when its products generated velocity.

Coleco’s financial policy showed no consistency with the huge risks associated with its operating strategy. The company relied on substantial amounts of debt financing—especially to finance product development and introduction—but this financing assumed product success and longevity, enough to repay the principal. Senior lenders, at least, were not persuaded that the debt could be easily serviced; Coleco resorted to financing itself with subordinated convertible securities. The heavy reliance on debt financing restricted the firm’s flexibility to respond to shocks. The issuance of shares of stock to satisfy lawsuits implies that management was even willing to dilute the old shareholders’ interest to remain in operation.

The dark side of Coleco’s strategy sharpened some classic agency conflicts between stockholders and creditors. These conflicts emerge most clearly in financial distress, although they are always present, regardless of the firm’s health. In particular, distress invites behavior that buys time for the residual investors and/or shifts risks from the junior to the senior claimants.

Illustration of creditor-shareholder conflicts[3]

Discussion Question 2

Exhibit TN2 gives the details for a discussion of risk shifting by creditors and shareholders. To begin, assume a one-period model, in which everything is liquidated a year later (except in the final case, when liquidation is immediate). The required return on assets (WACC) is 10 percent in the initial example.

Panel 1 of Exhibit TN2 illustrates the base case, before distress. Here, the firm has five equally likely values at the end of the year; the expected value is $110. The debt has a required return of 5 percent and a face value of $90, but because there is default risk, it has an expected value of only $84. Finally, the future expected value of the stock is $26, and its present value is $20. The implied return to shareholders is 30 percent.

Now, suppose the market learns that the firm has no new toys as originally thought. As shown in Exhibit TN2, panel 2, the payoffs on the value of the firm shift downward, but the risks (i.e., variance) remain the same; so the required return on assets is still 10 percent. As can be seen from the debt-payoff column, the creditors bear a higher default risk than the shareholders; so suppose that the required return on debt rises to 8 percent. As a result of this shift, the present values of the firm, the debt, and the equity fall to $63.64, $59.26, and $4.38, respectively. Value is destroyed by this development.

In the second case, shareholders have only a 20 percent chance of getting anything versus a 60 percent chance before. The bondholder has an 80 percent chance of being the residual owner (i.e., getting all the firm value at liquidation). Bondholders basically own the firm now, and stockholders own the “outside chance” of survival (i.e., an out-of-the-money call option on the assets, where the exercise price is $90 and the current asset value is $70).

Next, consider a new possibility: an investment opportunity arises in which the company could spend $20 more to produce a Cabbage Patch “follow-up” product that will either fail (i.e., lose the $20) or pay off handsomely, generating a value of the firm of $200 at the maximum, rather than $120 (Exhibit TN2, panel 3). The range of outcomes shows that this new project has the effect of widening the variance: the upside payoff rises considerably, while the payoff in the other four states falls by $20. Assume that, because of this higher variance, WACC rises to 18 percent and the cost of debt rises to 10 percent. Here, the value of the firm and the value of debt fall (to $59.32 and $43.64, respectively), while the value of equity rises (to $15.68). The net effect of the risky project is to create value for shareholders and destroy value for creditors. Intuitively, this outcome is consistent with viewing common stock as a call option on the assets of the firm: the option should be more valuable as variance increases.

Faced with the prospect of this kind of behavior, the bondholder at this point could attempt to (1) raise all expected payoffs so that everyone wins or (2) lower the risk, even if stockholders lose. In panel 4 of Exhibit TN2, bondholders “throw away” the upside potential in favor of a more certain liquidation value, which is assumed to be received immediately. The variance of payoffs on the assets is narrowed considerably. The present expected value of payoffs to bondholders ($68) is higher under liquidation, however, than it is under the shareholders’ new investment plan ($43.64).

To summarize, shareholders fare as follows:

Stock Price

Base case $20.00

No new products 4.38

High-flyer project 15.38

Liquidation $ 2.00

The naturally conflicting interests of creditors and shareholders tend to obscure the overriding possibility that both parties might be better off if they were to cooperate. One of the arts of restructuring a distressed firm is determining solutions that enhance the wealth of both creditors and shareholders while (re)gaining cooperation among them.

Valuing Coleco stock as