Capital Structure MBA 253
The Financing Decision The firm has limited ways to raise funds: Debt: Bank Debt, Commercial Paper and Corporate Bonds Equity: Owners Equity, Venture Capital, Common Stock and Warrants Hybrid Securities: Mixtures of Debt and Equity: Convertible Debt, Preferred Stock, Option Linked Bonds What mix of debt and equity should be used? (what is the firm’s Capital Structure)
Debt vs. Equity Debt Fixed Claim Tax Deductible High Priority in Financial Trouble Fixed Maturity No Management Control Equity Residual Claimant No Tax Deduction Lowest Priority in Financial Trouble No Maturity Management Control
Debt Bank Debt Small amounts, Intermediation for small firms, No ratings agencies - public information can be minimized Corporate Bonds Risk Sharing, special features Issues to be addressed Short or long term Fixed or Floating Rates Assets used as Security Special Features
Special Features of Debt Floating Rate Loans: Rate Varies with Index Puttable Bonds: Bond holders can receive face value Convertible / Exchangeable: Can be converted into Equity Extendable Life of Bond can be extended by borrower Caps and Floors: Limits rate movements of floatable bonds Swaps: Exchange of fixed for floating and vice versa Reverse Floating Rate Notes: Rate varies inversely with index Swapations: Options on a swap
Equity Owners Equity returning earnings on the seed money to the firm Venture Capital capital provided in return for ownership share Common Stock Warrants Holders receive the right to buy shares in the company at a fixed priced upon implied volatility create no financial obligation at time of issue Contingent value rights Investors can sell their stock at a fixed price
Warrants and Options Similar to a long term call option Difference is that exercising a warrant affects the value of the underlying asset (it increase the number of shares outstanding)
Hybrid Securities Convertible Debt Lowers the interest rate paid by the firm bondholder given the option to convert into stock Preferred Stock promised payment (like bonds) infinite life, limited voting privileges Option Linked Bonds Commodity linked bonds
Does Capital Structure Matter? WACC = rd(1 -t)wd + rpswps + rewe Generally: Keeping the risk level the same, Debt is less expensive than Equity However, Increasing debt, increases the risk to the shareholders, the cost of equity should increase due to the higher risk. Which has a larger influence: the decreased cost associated with the use of debt or increase cost associated with equity?
Debt Benefits and Cap Structure Debt ratios of firms with higher tax rates should be higher than those with lower tax rates Firms that have substantial non-debt tax shield (depreciation for example)should be less likely to use debt If tax rates increase over time so should debt ratios
The Costs of Debt Bankruptcy costs probability of bankruptcy Indirect and Direct Costs Agency Costs Creates tensions between shareholders and lenders Lost Flexibility Firms value the ability to take on new projects
Bankruptcy Probability Increases with The size of debt obligations relative to the size of operating cash flows The variability of cash flows Costs of Bankruptcy Direct Costs --Legal and administrative costs Indirect Costs -- decreased sales, availability of credit Indirect costs are higher when firms produce Durable products Products dependent on quality reputation Products requiring service and complementary products Products requiring support services
Bankruptcy and Cap Structure Firms in volatile industries should use debt less than firms in more stable industries If debt can be structured so that cash flows on debt increase and decrease with cash flows can borrow more If external protection from bankruptcy exists firms will borrow more Firms with non divisible and non marketable assets are more likely to use debt If products require long-term servicing should have lower leverage
Agency Costs Conflicts between Bondholders and Stockholders Investment decisions (risk shifting) Financing Decisions Dividend policy Agency costs are important when Bondholders believe that stockholder actions will increase chance of default Protective Covenants require monitoring costs and indirectly reduce flexibility The firms investments are not easily monitored projects are long term
Flexibility The ability to handle unforeseen contingencies that might arise Provides ability to undertake new projects Provides more breathing room Firms with large and unpredictable demands on cash flows will require higher flexibility As firms and industries mature the returns on projects become more stable and the desire of flexibility decreases
The Borrowing Trade off Advantages Tax Benefits Higher tax rate higher benefit Added Discipline The greater the separation between management and shareholders the greater the benefit Disadvantages Bankruptcy Costs Higher business risk implies Higher cost Agency Cost Greater separation between stockholders and lenders results in Higher Cost Loss of Flexibility Greater uncertainty implies Higher costs
Business Risk The riskiness of the firm’s assets if it uses no debt Looked at in a stand alone context Measured by the standard deviation of the firms ROA
ROA vs. ROE ROA = Return to Investors/Assets = (Net Income to Shareholders + Interest)/Assets Without the use of debt this becomes = (Net Income to Shareholders /Assets Which is ROE W/O debt business risk can be measured by the firms ROE.
ROE Variability in ROE is determined by: 1. 2. 3. 4. 5. 6. Demand Variability Sale Price Variability Input Cost Variability Ability to Adjust output prices Ability to develop new products Fixed Costs
Operating Leverage The portion of the firms costs that are fixed. Fixed costs must be paid regardless of sales – this increases risk The Breakeven point is therefore important - it is the amount of sales needed to cover fixed cost.
Breakeven Point The breakeven point occurs where the firm earns just enough to cover fixed and variable cost (EBIT = 0 and ROE = 0) EBIT=Price(Quant)-Varib. Cost(Q)-Fixed. C) Rearrange and solve for Q 0 = p. Q-VQ-F F = (P-V)Q Q = F/(P-V)
Financial Risk is the extra risk placed on shareholders when the firm decides to use debt. Above ROE = NI/asset=NI/equity (assets = equity when debt =0) Now NI declines and as debt increases and equity decreases. The net effect is an increase in ROE
An example Stratsburg Electronics 175, 000 in assets two choices 175, 000 equity or 87, 500 equity & 87, 500 debt Assume that the use of equity does not change the EBIT
Numerical Example Debt and Equity All Equity Expected EBIT 35, 000 Interest (10%) 8, 700 0 EBT 26, 250 35, 000 Taxes(40%) 10, 500 14, 000 Net Income 15, 750 21, 000 15, 750/87, 500 =18% 21, 000/175, 000 =12% Expected ROE
The Capital Structure Question Is there an “optimal” capital structure? Modigilani and Miller Capital structure is irrelevant The decrease in cost of capital from debt is offset by the increase in the cost of equity. Trade off Theories The capital structure that minimizes the WACC will also produce the highest shareholder value and is the optimal capital structure.
Modigliani & Miller Assumptions Firms can be classified by business risk ‚ All investors agree about the distribution of future earnings ƒ Perfect Capital Markets „ No Bankruptcy Costs …No income taxes † All cash flows are perpetuities ‡ EBIT is not changed by use of debt
M&M two propositions Value of leveraged firm = Value of Unleveraged Firm EBIT/ WACC = EBIT / r. SU r. SL = r. SU + (r. SU - rd) (D/S) where: r. SL = Cost of stock leveraged firm r. SU = cost of stock unleveraged firm rd = Constant cost of debt D = market value of debt S = market value of stock
M&M EBIT/WACC = EBIT/KSU r. SL=r. SU+(r. SU-rd)(D/S) Together this implies that the cost of capital doesn’t change as the amount of borrowing increases. Assumed that EBIT doesn’t change so WACC = r. SU regardless of the amount of debt used. WACC = wd rd + wsr. SL
An Example: EBIT/WACC = EBIT/KSU KSL=KSU+(KSU-Kd)(D/S) Assume that KSU = 10% Kd = 6% No Debt Value of firm = EBIT/ KSU 10% Debt KSL=KSU+(KSU-Kd)(D/S) KSL=. 10 + (. 10 -. 06)(1/9) KSL=. 104444 WACC = wd Kd + ws KSL WACC =. 10(. 06)+. 9(. 10444) WACC =. 10 Value of firm = EBIT/. 10
Including Taxes What if the interest payments on debt are tax deductible? Then WACC will decrease at the percentage of debt increases. This implies that the value of the firm will increase as the amount of debt increases. In fact the optimal capital structure would be 100% debt. Miller also showed that if personal income taxes are included that one possible scenario is still capital structure irrelevance. (see book for details)
If Debt Doesn’t Matter The cost of capital is unaffected by changes in the proportions of debt and equity The value of the firm is unaffected by leverage The investment decision can be made independently of the financing decision.
Tradeoff Theory Initially adding debt causes the WACC to decline. The tax benefit of debt causes the WACC to decrease for now bankruptcy costs are low. As the firm uses more debt bankruptcy costs start to increase. The decrease in the WACC is less for every unit of debt added. As the amount of debt increase, so do bankruptcy costs Eventually the indirect and direct costs to the firm outweigh the tax benefits and the WACC increases. This implies that a minimum WACC exists, at this point the value of the firm (EBIT/WACC) will be maximized.
Trade Off Theory If this is the case – the use of debt matters, The point were the WACC will be minimized will maximize the value of the firm
Empirical Evidence The Debt Ratio is: Negatively correlated with the volatility in annual operating earnings as predicted by bankruptcy costs Positively related to the level of non-debt tax shields opposite of what was predicted Negatively related to advertising and R&D expenses, as predicted by tradeoff theory Positively related to the marginal tax rate as predicted by the tradeoff theory Negatively related to the need for decision making flexibility as predicted by tradeoff theory Negatively related to variability in operating cash flows as predicted by tradeoff theory
Information Asymmetry Managers prefer retained earnings to external financing since external financing depends upon the market pricing the security If management believes that the market is overvaluing its securities it is more willing to issue new equity, even if projects don’t exist If management believes that the market is underpricing its securities it is less willing to issue new equity even if good projects exist.
Signaling Therefore issuing securities signals the market that firms believe their security is overvalued and it is interpreted as a negative signal. (The market believes the firm has negative information not publicly available) The signal is more negative if there is a greater possibility of asymmetry (stocks for example).
Capital Structure Decisions Rank 1 2 3 4 5 6 Source Principles Cited Retained Earnings None Straight Debt Max Security Prices Convertible Debt Cash Flow and Survivability External Common Avoiding Dilution of Equity Straight Pref Stock Comparability Convertible Pref None
Other Things to Consider Some final considerations in the capital structure decision 1) Long Run Viability 2) Managerial Conservatism 3) Lender and Rating Agency Attitudes 4) Financial Flexibility 5) Control 6) Asset Structure 7) Growth Rate 8) Profitability
Cap Structure: Models and Applications Cost of Capital Approach Analysis based on the cost to the firm of financing new projects (the WACC calculated earlier) Adjusted Present Value Valuing the firm by starting without leverage then adjusting its value as more debt is added Comparative Analysis Comparing the debt ratio and other financial information to industry averages
The Cost of Capital Approach Basic Idea: Attempt to maximize firm value by finding the level of debt that produces its minimum WACC. Procedure: Calculate the cost of debt, cost of equity and the WACC at various levels of debt to identify its minimum WACC.
WACC The weighted average cost of capital is defined as the weighted average of the cost of the different components of financing WACC = rdwd(1 -t) + rpswps + rewe where: rd = before tax cost of debt rps = cost of preferred stock rd = cost of debt equity t = firms marginal tax rate wd = % of financing from debt wps = % of financing from Pref stock wd = weight of financing from equity
WACC and Firm Value The value of the firm is the present value of its future cash flows (FCFF) discounted at the WACC (the hurdle rate) Value of the firm = S [FCFF/(1+WACC)t] Notice as the WACC decreases the value of the firm will increase, if the WACC increases the value of the firm will decrease.
WACC and Firm Value According to the present value formula as the discount rate decreases the PV of a future sum (or series of cash flows) will increase. If the tradeoff theory is correct there is a minimum WACC Does this imply that the Firm Value will be maximized at the point where the WACC is minimized?
WACC and Firm Value If the cash flows to the firm do not depend on the financing mix, the value of the firm is maximized when the WACC is minimized The Debt Equity ratio might cause a change in the FCFF, if this is the case the minimum WACC will not necessarily maximize firm value
Estimating the Cost of Capital* You need to estimate the WACC for different levels of debt. Develop an estimate for the cost of equity and various debt levels Develop an estimate for the cost of debt at various debt levels Combine 1 and 2 to find the WACC for various levels of debt.
Estimating the Cost of Equity Step 1 Estimate the equity beta (run regression or use analysts estimate) Step 2 Estimate the unlevered beta (Beta if the firm had no debt) u = current/[1+(1 -t)D/E] Step 3 Reestimate the levered beta for different levels of debt Levered = u[1+(1 -t)D/E] Step 4 Use CAPM to estimate the costs of equity from the levered betas re= r. RF+ Levered[E(rm)-r. RF)
Disney’s Optimal Capital Structure Step 1 Estimate Beta
![Disney’s Cost of Equity Step 2: Estimate the Unlevered beta: u = current/[1+(1 -t)D/E]](https://present5.com/presentation/8a23443d58186a554a5648d0c34758ac/image-48.jpg "Disney’s Cost of Equity Step 2: Estimate the Unlevered beta: u = current/[1+(1 -t)D/E]")
Disney’s Cost of Equity Step 2: Estimate the Unlevered beta: u = current/[1+(1 -t)D/E] Disney’s D/E Ratio = Long Term Debt = 12. 67 Billion Market Capitalization =65. 74 Billion D/E = 12. 67/65. 74 =. 19% Assuming a 36% tax rate u= current/[1+(1 -t)D/E] = 1. 094[1+(1 -. 36)(. 19)] = 0. 975
Disney Cost of Equity Step 3 Reestimate the levered beta at different levels of debt Lev= u[1+(1 -t)D/E]
Disney’s Cost of Equity Step 4 Estimate cost of equity using Levered in the CAPM let r. RF = 5% r. M- r. RF =. 0482% Re=r. RF+ (r. M-r. RF)
Estimate the Cost of Debt Step 1 Step 2 Step 3 Step 4 Step 5 Step 6 Compute the market value of the firm MV of firm = MV of Debt + MV of Equity Compute $ value of debt at various debt ratios $Value of Debt = D/(D+E)(MV of firm) Compute the amount paid in interest at each debt ratio = (Interest rate)($value of Debt) Estimate the Interest Coverage Ratio = EBIT/Interest Expense Use the Interest coverage ratio to determine bond ratings and interest rate spreads Use Spreads to find before tax cost of debt
A Viscous Circle You need the interest rate to calculate the interest payments. Then use the interest payment to determine the interest coverage and rating to find the interest rate. Use iterative procedure to find consistent rates, Assume AAA use rate then estimate rate, if they are not the same repeat the process. . .
Disney’s Cost of Debt Step 1 Compute the market value of the firm MV of firm = MV of Debt + MV of Equity = 12. 67 Billion+ 65. 74 Billion = 78. 41 Billion Use this as the current amount of financing undertaken by the firm (we want to find the $ value of debt at various debt ratios)
Disney’s Cost of Debt Step 2 Compute $ value of debt at various debt ratios $Value of Debt = (Debt/(D+E))(MV of firm)
Disney’s Cost of Debt Step 3 Compute the amount paid in interest at each debt ratio = (Interest Rate)($value of Debt) The problem is that you have to assume an interest rate then continue with Steps 4 and 5 to see if your assumption was correct. Your assumption of the rate is based upon the likely rating for the firm. Starting with the increase from 0% to 10% debt assume that the firm is ranked AAA. Then look at the table relating bond ratings to rates to estimate the rate.
Bond Ratings and Average Yield Spreads vs. US Treasuries (long term bonds) Rating Spread AAA. 35% AA. 50% A+. 70% A. 85% A- 1. 00% BBB 1. 5% BB 2. 0% Int Cov Rating Spread >12. 5 B+ 2. 5% 9. 5 -12. 5 B 3. 25% 7. 5 -9. 5 B 4. 25% 6. 0 -7. 5 CCC 5. 00% 4. 5 -6. 0 CC 6. 00% 4 -4. 5 C 7. 5% 3 -3. 5 D 10. 0% Int Cov 2. 5 -3 2 -2. 5 1. 5 -2 1. 25 -1. 5 0. 8 -1. 25 0. 5 -0. 8 <0. 5
Disney’s Cost of Debt Step 3 A rating of AAA implies a 5. 35% interest rate for the firm (0. 35% spread over the long term rate) Given the interest rate you can calculate the interest expense = (Interest Rate)($ Value of Debt) =(0. 0535)(7. 84) =. 4194 Billion Use this number to calculate the interest coverage ratio in step 4
Disney’s Cost of Debt Steps 4 & 5 Step 4 Estimate the Interest Coverage Ratio = EBIT/Interest Expense Disney’s EBIT = 5. 301 Billion Interest coverage ratio at 10% D/(D+E) = 5. 301/0. 4194 = 12. 634 An interest coverage ratio of 12. 634 implies a bond rating of AAA, so 5. 35% is correct. If the interest coverage ratio did not imply the same rating as your assumption, go back to step 3.
Ratings and Interest Coverage Ratios Rating Coverage ratio Interest rate 12. 63 AAA 12. 5 to infinity 5. 35% Implies a bond AA 9. 5 to 12. 5 5. 50% rating of AAA A+ 7. 5 to 9. 5 5. 70% A 6. 0 to 7. 5 5. 85% A 4. 5 to 6. 0
A Second Example Using a 20% D/(D+E) and still the assumption that the firms debt will be ranked AAA implying a 5. 35% cost of debt The $ value of debt is 15. 682 Billion Implying $ expense of 15. 682(. 0535) =. 83898 Billion The interest coverage ratio is 5. 301/. 83898 = 6. 3183866 which implies a bond rating of. . .
Ratings and Interest Coverage Ratios Rating Coverage ratio Interest rate AAA 12. 5 to infinity 5. 35% AA 9. 5 to 12. 5 5. 50% A+ 7. 5 to 9. 5 6. 31 5. 70% Implies a bond A 6. 0 to 7. 5 rating of A 5. 85% A 4. 5 to 6. 0
Ratings and Interest Coverage Ratios Since the interest coverage ratio implies that the bond should be rated A assume that the rate is 6. 00% The $ value of debt is 15. 682 Billion Implying $ expense of 15. 682(. 0585) =. 91739 Billion The interest coverage ratio is 5. 301/. 91739 = 5. 77 Checking the table…….
Ratings and Interest Coverage Ratios Rating Coverage ratio Interest rate AAA 12. 5 to infinity 5. 35% AA 9. 5 to 12. 5 5. 50% A+ 7. 5 to 9. 5 5. 70% A 6. 0 to 7. 5 5. 85% A 4. 5 to 6. 0 5. 77 Implies a bond rating of A-
A Second Example Using a 20% D/(D+E) and still the assumption that the firms debt will be ranked A- implying a 6. 00% cost of debt The $ value of debt is 15. 682 Billion Implying $ expense of 15. 682(. 06) =. 94092 Billion The interest coverage ratio is 5. 301/. 94092 = 5. 63 which implies a bond rating of. . .
Ratings and Interest Coverage Ratios Rating Coverage ratio Interest rate AAA 12. 5 to infinity 5. 53% AA 9. 5 to 12. 5 5. 50% A+ 7. 5 to 9. 5 5. 70% 5. 63 A 6. 0 to 7. 5 Still Implies a bond 5. 85% rating of A- !!! A 4. 5 to 6. 0
Ratings and Interest Coverage Ratios Since the assumed rate and the corresponding actual rate agree, the cost of debt for a weight in debt of 20% is then set to be 6. 00% and the process is repeated for 25% debt, 30% debt etc… Remember that these are before tax cost of debt, and they will need to be adjusted in the cost of capital formula.
Disney’s Cost of Debt Steps 3 and 4 for debt from 10% to 60% - complete this for a range from 0 to 100% debt
Cost of Capital Using the cost of equity and cost of debt at various debt levels you can find the WACC of each level of debt. Remember, the debt level determine the weights of each type of financing (the capital structure).
WACC at Different Debt Levels
Optimal Debt Ratio
Minimum WACC The minimum WACC occurs at approximately 25% debt. This is the “Optimal” amount of debt for the firm The value of the firm could then be found assuming that the future FCFF can be estimated.
FCFF = EBIT(1 -t) + Depreciation - Capital Spending Disney’s 2005 financial statements show that EBIT = 5. 301 Billion Depreciation = 1. 339 Billion Capital Spending = 1. 823 Billion Assuming a tax rate of 36% FCFF = 5. 301(1 -. 36)+1. 339 – 1. 823 = 2. 9086
Firm Value and WACC In General the value of the firm is the present value of its discounted cash flows: If the cash flows are constant over time similar to a perpetuity this reduces to
Constant growth in FCFF This is the same formula as for valuing stocks with constant growth in dividends (now the cash flows being discounted are FCFF instead of Dividends. Let g be the constant rate of growth in FCFF then the value of the firm is given by:
Annual Savings Disney is currently operating at a debt level of 16%. But its optimal debt level is 30% The annual financing cost at the current debt ratio is 78. 41(. 09242) = 7. 2466 Billion At a debt level of 25% (WACC =. 08985) The annual financing costs would be equal to 78. 41(. 08985) = 7. 0421 Billion This implies an annual savings of 7. 2466 B-7. 0421 = $201. 46 Million IF the firm moves to its optimal capital structure
Implied Growth Rate Rearrange to find the growth rate
Implied Growth Rate Use the current MV of the firm from before as the PV PV=78. 41 B, FCFF = 2. 9086 Billion, WACC =. 08985% 78. 41 . 08985 2. 9086 . 05087 2. 9086 78. 41
Assuming that the annual savings also grows at the implied growth rate of 7. 36%, the PV of the annual savings will represent an increase in the value of the firm since it reduces its yearly interest expense.
Share Price The value of the firm increased by 5. 431 Billion, this can be transformed to a per share value by dividing by the number of shares outstanding. The resulting number should represent an increase in the share price of the firm. It would be the increase in the PV of the future cash flows to the firm. Given 2. 1 Billion Shares issued: 5. 431/2. 113 = $2. 57 The share price should increase by $2. 57 or 2. 57/31. 45 = 8. 1%
Final Thoughts The model assumes that the relationship between bond ratings and risk premiums is the same over time The model assumes that all debt will be refinanced at the new level of interest rates Is this the optimal capital ratio if the bonds are ranked below investment grade?
Adjusted Present Value Start with the PV of the firm assuming that there is no debt As debt is added adjust the present value to account for the positive and negative effects of adding debt. Assuming that the largest benefit of borrowing is the tax saving and the largest source of costs are bankruptcy costs: Value of PV of Levered = Unlevered + Tax Benefits - Bankruptcy Firm of debt Costs
Value of Unlevered Firm Assumes that the firm has no debt. this requires an estimate of the unlevered cost of equity. The unlevered cost of equity is found by using the unlevered beta in the CAPM The value of the unlevered firm is then:
Tax Benefit The expected tax benefit from borrowing is based upon the level of debt in the firm. Each years tax savings equal the tax rate multiplied by the amount of debt multiplied by the cost of debt The benefit should be discounted at the cost of debt PV of tax benefit = (Tax rate)(Cost of Debt)(Debt) Cost of Debt = (Tax Rate)(Debt) Note: The cost of debt changes as the level of debt changes
Expected Bankruptcy Costs The expected bankruptcy costs depends upon the probability of default The probability of default will increase as the firm increases its use of debt. The expected bankruptcy cost is the probability of default multiplied by the PV of the bankruptcy costs if the firm defaults. PV of Expected Probability Bankruptcy = of Costs Bankruptcy PV of x Bankruptcy Costs
Optimal Debt Ratio To find the optimal debt ratio the adjusted value of the firm needs to be calculated at various levels of debt The level of debt that maximizes the adjusted value of the levered firm is the one that is the optimal level of debt.
Disney Step 1: Using our numbers from before estimate the value of the unlevered firm: Value of PV of Levered = Unlevered + Tax Benefits - Bankruptcy Firm of debt Costs Rearranging Value of PV of Un. Levered = Levered - Tax Benefits + Bankruptcy Firm of debt Costs
Disney The Numbers Value of Levered Firm = MV of the Firm = $78. 41 B PV of Tax benefits = (value of debt)(tax rate) = 15. 682(0. 36) = 5. 6551 B PV of Bankruptcy Costs = 78. 41 B(. 25)(. 0053) = $. 10389 M Based on bankruptcy cost of 25% of firm value and the probability of default (from your textbook) associated with A rated debt Value of PV of Un. Levered = Levered - Tax Benefits + Bankruptcy Firm of debt Costs 72. 8788 B = $78. 41 - $5. 6651 + $. 10389
Step 2 Estimate the tax benefits and expected bankruptcy costs at various levels of debt. Start with the Value of the unlevered firm then adjust for the PV of tax Benefit and PV of Bankruptcy Costs
Step 3 Estimate the value of the levered firm at various debt levels
Adjusted Present Value
Comparative Analysis Compare debt ratio to similar firms, Easiest approach is to compare to the industry average. The most important thing is to then investigate why the firm might have a higher or lower debt ratio than the average.
The Financing Details If the firm is not at its optimal level of debt it must decide if it wants to move toward its optimal level. Outside pressure often plays a key role in making this decision. If it decides to move toward its optimal level it has two choices. Gradual Change --Change only new projects or also adjust existing ones? Quick Change
Immediate or Gradual The decision of an unlevered firm to change its debt ratio is based upon Degree of Confidence in the Optimal Estimate Comparability of Peer Groups Likelihood of a takeover Need for flexibility (financing slack)
? ? Speed of Change ? ? Assume that a firm which currently has more debt than identified as its optimal level has substantial indirect bankruptcy costs. Is the speed that it attempts to return to its optimal level affected by its bankruptcy costs?
Increasing Leverage Quickly Borrowing money and buying back stock Debt for Equity Swap Using the proceeds from the sales of assets to buyback stock
Why Increase Leverage Quickly? Often to avoid a hostile takeover bid. Firms with large cash balances are prime targets for takeover. Some recent examples of increased leverage to fight a takeover are CBS Inc. in 1986 Bought back 21% of Stock Goodyear Tire 1986 Sold three units and bought back 20 Million shares Phillips Petrol. 1984 Doubled debt to buy back shares
Decreasing Leverage Quickly Creates a problem since the it signals that the firm is desperate to decrease its debt level (It might not survive if it doesn’t decrease its debt level) Most often this happens in one of two ways Renegotiating debt agreements. Convincing lenders to take an equity stake in the firm Selling assets and using proceeds to retire some debt Which assets should the firm sell? Worst performing, Best performing or most liquid?
Increasing Leverage Gradually The ability to increase the firms leverage gradually allows the firm to look for quality projects. Some possible ways of increasing the portion of debt include: Increasing the Dividend Payout Ratio Repurchasing stock each year Increasing Capital expenditures
Decreasing Leverage Gradually Firms can finance new projects with retained earnings, lowering the amount of debt used by the firm. Lowering (or suspending) dividend is another approach (although not one favored by shareholders) to decreasing the debt level.
Details of New Finance The firm needs to specify the details that outline either its new equity (common stock, warrants or contingency rights) or debt (maturity, fixed or floating, conversion options. . ) Will discuss a series of steps that will help in the decision making process
Details Examine the Cash Flow Characteristics Want to match Cash Flows and Liabilities (duration, fixed or floating rates, inflation, currency risk. . . ) Examine the tax implications Consider the response of Rating Agencies Examine the effects of Asymmetric Information Consider any Agency Costs A Sensitivity Analysis
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