Read the Readers Digest Mini Case (PDF) and answer the following questions:

Readers Digest Mini Case Adam Rust and Jenna Hawthorne were newly hired financial analysts for Readers Digest Association, publisher of the worlds bestselling magazine. Their first assignment had been a big one performing a financial statement analysis of the firm. Readers Digest had just purchased another magazine publisher, Reiman Industries. The firm had taken on a $950 million loan to pay for the acquisition. However, only $726.3 million of the loan would be used to purchase Reiman. The remainder, $223.7 million, would be used to repurchase shares. Readers Digest had two classes of shares, non-voting A shares and voting B shares. All of the B shares were to be repurchased or exchanged for A shares, so after the reclassification, Readers Digest would have only one class of shares, A shares, which would all be voting shares. A shares, trading under RDA on the New York Stock Exchange, currently sold for $20.85 a share. The B shares would be repurchased at a premium for $27.78. The shares were purchased at a premium because the represented control. Control has value, and the $27.78 price was negotiated by the B shareholders and the firm. The $950 million loan carried a 6% interest rate and had the following repayment of principal schedule: Year 1: $132 million Year 2: $32 million Year 3: $57 million Year 4: $82 million Year 5: $82 million Year 6: $565 million With the Reiman acquisition, Readers Digest was expecting: Revenues $2,824.4 million Operating Profit $ 263.1 million Net Income $ 110.9 million Total Assets $2,829 million Book Value Equity $436.3 million Number of common shares outstanding before repurchase: 102.7 million Dividend per share: $0.20 Tax rate: 30% Now Adam and Jenna were asked to evaluate the impact of the loan on Readers Digest common shareholders. Was any value being created by the loan? Would this impact earnings per share and return on equity for shareholders? Adam and Jenna were also puzzled by the lawsuits Readers Digest was also facing. Up until this year, Readers Digest had two classes of stock, A shares and B shares, both traded on the New York Stock Exchange. However, only B shares had voting privileges. All of the shares had equal claim on the firms net income and the dividend per share was the same for all shares. Readers Digest announced that it was reclassifying all of its shares into voting A shares. All B shares would be either bought back by the firm or converted into A shares. Each B share would be converted into 1.24 A shares. After the announcement, Readers Digest was sued by several A shareholders who said that the proposed recapitalization was unfair to them and also sued by B shareholders who made the same claim that the reclassification was unfair to them. Adam and Jenna were both looking at participating in the firms employee stock purchase plan which would allow them to purchase A shares at a 10% discount to the market price. They didnt understand what impact the reclassification would have on their future A shares and how both A and B shareholders could be unhappy about the reclassification.

1. What is the present value of the term loan? What would the present value be if Readers Digest had chosen permanent debt instead of a term loan?
2. What is the impact on common shareholders of the repurchase? What are the new and old earnings per share, return on equity and stock price? Would it make a difference if market values vs. book values were used in the calculations?
3. How could Readers Digests market price be impacted by the decision to purchase Reiman? How would Readers Digest know if this acquisition should be made? How can the company assesses the markets evaluation of its acquisition decision?
4. Does it make sense for Readers Digest to offer B shareholders more than one A share for every B share that they own? Why might both types of shareholder be unhappy with the reclassification of shares?