Reader's Digest Case Study

The main issues at stake in determining the capital structure of the Reader’s Digest acquisition of Reiman are the impact of potential preferred stock; the impact of expansion of current stock; and the potential impact of a term loan.

One potential financing option presented to Reader’s Digest is to issue preferred stock. The preferred stock offering does not carry the same tax advantages that debt carries. The cost of the preferred stock is 5%. Preferred stock would be a fairly uncommon tactic to take by a company in the position of RDA. Preferred stock is more commonly used by financially distressed companies. Financially struggling companies may benefit from preferred stock because they may not have any income to shield from taxes if they are struggling. One benefit of offering preferred stock would take place in a downturn for RDA. It is much easier to skip a preferred dividend payment, then an installment on a loan. Most preferred stock has cumulative dividends, which would help ease short term struggles.

Reader’s Digest’s second alternative is to issue new common stock. RDA’s cost of equity can be computed using the capital asset pricing model, and comes out to around 10%. Issuing additional common equity versus debt and preferred stock usually comes with higher costs. With a price of $0.85 per share, to raise $950 million at $20 a share, RDA would need to issue 47,500,000 new common shares. The total cost would be $0.85 x 47,500,000 = $40,375,000. You also have to consider that current stockholders would have their equity position diluted. RDA has 102,650,000 common shares outstanding currently. Adding an additional 47.5 million shares would mean dilution of nearly one-third. A common way to offset this is to create a separate class of stock to protect the voting rights of the previous stockholders, but RDA is also attempting to eliminate the different classes of stock they currently have. Often times, firms who choose to issue additional equity do so in...