Debt Policy at UST Inc.
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Transcript of Debt Policy at UST Inc.
1
Debt Policy at UST Inc.
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Summary Financial Information for UST ($ Million)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 5-Yr CAGRSummary Operarting Dataa
Net Sales $611.90 $673.90 $756.40 $898.40 $1,032.20 $1,097.50 $1,204.00 $1,305.80 $1,371.70 $1,401.70 $1,423.20 5% Gross Profit 437.3 488.4 564.6 670.9 775.4 851.1 952 1043.6 1098.9 1109.8 1139.7 EBITDA 277.9 315 368.6 446.4 525.2 591.4 668.9 736.9 779.2 749.8 785 6% EBIT 260.2 298.4 349 423.8 500.8 564.8 640.7 707.8 750.9 719.3 753.3 6% Interest Expense (Income) -1.1 -3.2 -3.2 -2.3 -1.9 -2 0.1 3.2 6.4 7.5 -2.2 Pretax Earnings 261.3 301.6 352.2 426.1 502.6 566.8 640.6 704.6 744.5 703.9 755.5 Net Income 162.2 190.5 223.3 265.9 312.6 347.9 387.5 429.8 464 443.9 467.9 6% Free Operating Cash Flow $135.20 $195.10 $217.80 $247.30 $267.90 $340.70 $399.20 $521.20 $456.40 $287.40 $429.50 5% Special Charges/Non-Recuring Items (Gains)b ($35.00) $8.00 $21.00 Basic Earnings per Share $0.74 $0.87 $1.04 $1.26 $1.49 $1.67 $1.92 $2.21 $2.48 $2.41 $2.52 9% Diluted Earnings per Share $0.71 $0.83 $0.99 $1.20 $1.43 $1.63 $1.88 $2.17 $2.44 $2.39 $2.50 9% Dividend per Share $0.37 $0.46 $0.55 $0.66 $0.80 $0.96 $1.12 $1.30 $1.48 $1.62 $1.62 11% Dividend Payout Ratio 50% 53% 53% 52% 54% 58% 58% 59% 60% 67% 64%
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Summary Financial Information for UST ($ Million)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998Balance Sheet and Cash Flow Data Cash and Cash Equivalents $72.70 $54.60 $46.60 $41.50 $36.40 $25.30 $50.70 $69.40 $54.50 $6.90 $33.20 Total Assets $598.00 $630.20 $622.60 $656.50 $674.00 $706.20 $741.20 $784.00 $806.60 $826.40 $913.30 Long-Term Debt $21.80 $6.80 $3.10 $40.00 $125.00 $100.00 $100.00 $100.00 $100.00 Total Debt $30.80 $14.50 $4.80 $1.30 $40.00 $125.00 $200.00 $250.00 $110.00 $100.00 Shareholders' Equity $453.30 $482.30 $473.90 $482.90 $516.60 $463.00 $361.70 $292.80 $281.20 $436.80 $468.30 Average Basic Shares Outstanding 220.6 219.8 215.2 211.6 209.8 208.5 202 194.4 187.4 183.9 185.5 Working Capital $221.10 $209.30 $197.20 $210.00 $249.00 $228.40 $221.20 $144.80 $144.00 $275.30 $309.90 Capital Expendituresc $20.80 $23.70 $37.20 $28.40 $30.10 $54.50 $23.70 $14.00 $36.70 $55.80 $35.50 Dividends paid $81.70 $101.20 $118.30 $139.70 $168.00 $199.70 $225.70 $252.40 $277.30 $298.10 $301.10 Share Repurchases $67.40 $97.50 $151.30 $184.40 $212.60 $236.70 $298.80 $274.80 $237.80 $45.70 $151.60
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Summary Financial Information for UST ($ Million)
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 5-Yr CAGRStock Price Data High $10.50 $15.38 $18.25 $33.88 $35.38 $32.75 $31.50 $36.00 $35.88 $36.94 $36.88 Low $6.00 $9.63 $12.38 $16.38 $25.38 $24.38 $23.63 $26.63 $28.25 $25.50 $24.56 Year End $10.25 $15.31 $18.25 $32.75 $32.00 $27.75 $27.88 $33.38 $32.38 $36.94 $34.88 5% Price/Earnings Ratiod 13.9x 17.6x 17.5x 26.0x 21.5x 16.6x 14.5x 15.1x 13.1x 15.3x 13.8x Market Equitye $2,260.60 $3,366.00 $3,926.60 $6,930.00 $6,713.70 $5,785.00 $5,630.60 $6,487.20 $6,066.60 $6,794.00 $6,470.80Selected Growth Rates and Ratios Sales Grow th 7.20% 10.10% 12.30% 18.80% 14.90% 6.30% 9.70% 8.50% 5.00% 2.20% 1.50% Net income Grow th 23.90% 17.50% 17.20% 19.10% 17.50% 11.30% 11.40% 10.90% 8.00% -4.30% 5.40% Dividend Grow th 23.30% 24.30% 19.60% 20.00% 21.20% 20.00% 16.70% 16.10% 13.80% 9.50% 0.00% Gross Profit Margin 71.50% 72.50% 74.60% 74.70% 75.10% 77.50% 79.10% 79.90% 80.10% 79.20% 80.10% 79.70% EBITDA Margin 45.40% 46.70% 48.70% 49.70% 50.90% 53.90% 55.60% 56.40% 56.80% 53.50% 55.20% 55.50% EBIT Margin 42.50% 44.30% 46.10% 47.20% 48.50% 51.50% 53.20% 54.20% 54.70% 51.30% 52.90% 53.30% Net Margin 26.50% 28.30% 29.50% 29.60% 30.30% 31.70% 32.20% 32.90% 33.80% 31.70% 32.90% 32.70% Return on Average Equity 38.00% 40.70% 46.70% 55.60% 62.50% 71.00% 94.00% 131.30% 161.70% 123.70% 103.40% 122.80% Return on Average Assets 28.30% 31.00% 35.60% 41.60% 47.00% 50.40% 53.50% 56.40% 58.30% 54.40% 53.80% 55.30% Long-Term Debt/Capitalization 4.60% 1.40% 0.60% 0.00% 0.00% 8.00% 25.70% 25.50% 26.20% 18.60% 17.60% 22.70% Total Debt/Capitalization 6.40% 2.90% 1.00% 0.30% 0.00% 8.00% 25.70% 40.60% 47.10% 20.10% 17.60% 30.20%
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Summary Information for UST and Peer Companies
UST Inc. Philip MorrisNorth
Atlantic Trading Co.
RJR Nabisco Holdings
DiMon Inc.Standard
CommercialUniversal
Corp
Summary Operating Dataa
Fiscal Year End 31-Dec-98 31-Dec-98 31-Dec-98 31-Dec-98 30-Jun-98 31-Mar-98 30-Jun-98Net Sales $1,423.20 $74,391.00 $93.10 $20,563.00 $2,171.80 $1,492.80 $4,287.20Gross Profit 1139.7 30993 60.9 9493 266.9 145 613.6
EBITDAb 785 15501 36.3 3602 200.2 85.8 329.5
EBITb 753.3 13811 29.1 2467 156.7 65.3 278.4Interest Expense (Income) -2.2 890 24.9 880 83.8 37.8 64Pretax Earnings 755.5 12921 4.2 1455 72.9 37.1 231.3Net Income 467.9 7672.4 1 718 52 26.9 130.4Free Operating Cash Flow $429.50 $6,076.40 $14.50 $2,016.00 $52.50 ($61.30) $110.20
Special Charges/Non-Recurring Items (Gains)c $21.00 $3,834.00 $2,069.00 $16.90 ($16.70)Basic Earnings per Share $2.52 $3.16 ($7.09) $2.22 $1.17 $2.18 $3.71Diluted Earnings per Share $2.50 $3.14 ($7.09) $2.22 $1.16 $2.05 $3.68Dividend per Share (Common) $1.62 $1.68 $2.05 $0.66 $1.11Dividend payout Ratio 64% 53% 0% 92% 56% 0% 30%
Tobacco Product Manufactures Tobacco Leaf Merchants
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Summary Information for UST and Peer Companies
UST Inc.Philip Morris
North Atlantic
Trading Co.
RJR Nabisco Holdings
DiMon Inc.Standard
CommercialUniversal
Corp
Balance Sheet and Cash Flow DataCash and Cash Equivalents $33.20 $4,081.00 $2.80 $300.00 $18.70 $34.10 $79.80Total Assets $913.30 $59,920.00 $260.00 $28,892.00 $1,797.50 $839.50 $2,056.70long-Term Debt $100.00 $12,615.00 $202.60 $9,982.00 $797.00 $197.10 $263.10Total Debt $100.00 $14,662.00 $215.60 $10,467.00 $1,079.50 $469.90 $849.60Preferred Stock & Minority Interest $39.30 $957.00 $0.50 $30.30 $31.70Shareholders' Equity $468.30 $16,197.00 ($15.40) $7,809.00 $421.90 $149.60 $547.90Average Basic Shares Outstanding 185.50 2,429.00 528.20 323.90 44.50 12.40 35.20Workding Capital $309.90 $3,851.00 $42.00 ($259.00) $706.40 $219.10 $328.80
Capital Expendituresd $35.50 $18.4.0 $0.50 $576.00 $36.60 $9.70 $90.00Stock Price Data
Fiscal year End $34.88 $53.50 Nah $29.69 $11.25 $15.94 $37.38
Price/Earnings Ratioe 13.8x 16.9x Nah 13.4x 9.6x 7.3x 10.1x
Market Equityf $6,470.80 $129,951.50 Nah $9,614.40 $500.30 $197.30 $1,315.20
Tobacco Product Manufactures Tobacco Leaf Merchants
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Buyback and Earnings
Year 1 Year 2 Year 3 Year 4Earnings 100 100 100 100Shares outstandingMonths 0-6 100 100 50 50Months-6-12 100 50 50 50Average shares outstanding 100 75 50 50EPS 1.00 1.33 2.00 2.00Change in EPS 33.33% 50.00% 0.00%
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Buyback and Earnings
Year 1 Year 2 Year 3 Year 4Earnings @ 20% growth rate 100 120 144 172.8Shares outstandingMonths 0-6 100 100 50 50Months-6-12 100 50 50 50Average shares outstanding 100 75 50 50EPS 1.00 1.60 2.88 3.46Change in EPS 60.00% 80.00% 20.00%EPS if no buyback 1 1.2 1.44 1.728Change in EPS 20.00% 20.00% 20.00%
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Buyback Need not to Increase EPS Always
Year 1 Year 2 Year 3 Year 4No. of Shares 1000 @ 1Operating profit 100 100 100 100Interest Income on Excess Cash@10% interest 30 30 30 30Earnings 130 130 130 130EPS 0.13 0.13 0.13 0.13After Buyback of 100 shares for 3 per shareOperating profit 100 100 100 100Interest Income on Excess Cash@10% interest 0 0 0 0Earnings 100 100 100 100EPS 0.11 0.11 0.11 0.11After Buyback of 300 shares for 1 per shareOperating profit 100 100 100 100Interest Income on Excess Cash@10% interest 0 0 0 0Earnings 100 100 100 100EPS 0.14 0.14 0.14 0.14
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Buyback and Debt Capacity Impairment
DE ratio increases leading to running off with debt capacity – may be only at book value
May be the change in DE ratio overstates the change in company’s level of financial risk and reduction of borrowing capacity
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Other Issues of Buyback
Management trying to squeeze out a few more EPS in deteriorating situation to meet the market’s forecast
May not be a meaning restructuring of the company May not be a genuine change in management attitude
towards maximizing stockholders’ value Simply a cyclical attempt to retain control over the
stockholders’ investment
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Summary Information for UST and Peer Companies
UST Inc.Philip Morris
North Atlantic
Trading Co.
RJR Nabisco Holdings
DiMon Inc.Standard
CommercialUniversal
Corp
Selected Growth Rates and RatiosSales Growth 1.50% 3.20% 10.20% -0.50% 2.20% 10.20% 4.20%Gross profit Margin 80.10% 41.70% 65.40% 46.20% 12.30% 9.70% 14.30% 28.00%EBITDA Margin 55.20% 20.80% 39.00% 17.50% 9.20% 5.70% 7.70% 13.40%EBIT Margin 52.90% 18.60% 31.30% 12.00% 7.20% 4.40% 6.50% 9.60%Net Margin 32.90% 10.30% 1.10% 3.50% 2.40% 1.80% 3.00% 2.70%Return on Average Equity 103.40% 49.30% NM 8.40% 12.50% 22.50% 25.60% 22.50%Return on Average Assets 53.80% 13.20% 0.40% 2.40% 2.70% 3.40% 6.50% 3.10%Long-Term Debt/Capitalization 17.60% 43.80% 89.40% 53.20% 65.40% 52.30% 31.20% 52.80%Total Debt/Capitalization 17.60% 47.50% 90.00% 54.40% 71.90% 72.30% 59.40% 65.70%
Tobacco Product Manufactures Tobacco Leaf Merchants
Median (excl.UST)
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Key Financial Ratios for Tobacco Companies
Three-Years (1996-1998)
Philip Morris
North Atlantic
Trading Co.a
RJR Nabisco Holdings
DiMon Inc.Standard
CommercialUniversal Corp
Tobacco Companies
MedianbUST Inc.
Corporate Credit Rating A B+ BBB- BB+ BB- A-Outlook Stable Stable Stable Negative Positive StableEBIT interest coverage (x) 11.2 1.3 2.5 2.6 3.3 3.5 3 101.5EBITDA interest coverage (x) 12.7 1.6 3.7 3.3 5.4 4.4 4.1 105.6Fund flow/total debt (%) 56.3 6.8 14.5 12.3 6.7 18.5 13.4 364Free operating cash flow/total debt (%) 41.8 5.6 6.8 10.1 -2.6 2.9 6.2 296.5Return on capital (%) 38.4 11.8 10.3 13.4 6.6 16.9 12.6 140.6Operating income/sales (%) 26 38.1 15.6 16.4 3.6 7.6 16 55.7Total debt/capital (including ST debt) (%) 49.3 90.6 55.1 67.8 77.5 65.8 66.8 28.2
Tobacco Product Manufacturers Tobacco Leaf merchants
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Factors to be Considered by Lender
Brand name and market positions Cash flow generations Cyclically Product diversification Geographical diversification Asset tangibility Litigations
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Capability to service Debt of $1 Billion
Even at interest rate of 8.7% (Ex. 7) interest will be only 11% of forecasted EBIT
Lower rating factors.. Litigation risk Less tangible assets Single-product risks
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Industrial Senior Debt Rating Distributions (1999)
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Discussion Question
Is debt for replacing equity a good idea?
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Income Statement Projections
Actual 1998
Pro-forma1999
Prof-forma 1999
Prof-forma 1999
Pro-forma 1999
Sales 1,423 1,494 1,494 1,494 1,494 5% anuual GrowthEBIT 754 792 792 792 792 53% of salesInterest -2.2 0 70.5 78.2 87Pre-tax earnings 756 792 721 714 705Taxes 287 301 274 271 268 38% tax rateNet Income 469 491 447 443 437Net Debt 0 0 1000 1000 1000Interest Rate 7.05% 7.82% 8.70%Interest Coverage 11.23 10.13 9.10Debt Rating A BBB BB
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Valuation Model
StatusQuo
$1 BillionRecap Plan
PV Tax Shields 380Value of UST 6469 6849Net Debt 0 1000Stock Price 34.875 36.924Shares Repurchased 27.08Shares 185.5 158.4Market Equity 6469 5849Debt/Market Equity 0 0.17
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Impact of Capital Structure on Firm Value
Debt Ratio0%
99%
Beta is unlevered betaCost of equity is cost of capital
As debt ratio increases, beta increases:Levered Beta = Unlevered Beta (1+ (1-t) (Debt/Equity))
As debt ratio increases,interest expenses increase.Interest coverage ratio drops and rating declines. Thisincreases the cost of debt
Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + After-tax Cost of Debt (Debt/(Debt + Equity))
If interest expenses exceedthe EBIT, the tax benefit willdecline:Tax rate = EBIT/Interest Exp *Tax rate
As cost of capital changes,Change in firm value = (Old Cost of capital - New Cost of Capital)(Current firm value)(1+g) /(New Cost of Capital-g)If investors are rational, increase in stock price = Change in firm value/ Total number of shares outstandingIf stock can be bought at today’s price, Increase in stock price = Change in firm value/ Remaining shares outstanding.
Three key assumptions:1. Operating income remains unchanged as the debt ratio changes2. All existing debt is refinanced at the new cost of debt3. Debt is used to buy back stock rather than invest in projects
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Debt and Value of Firm
Increase with more debt if the following factors not considered..,
Financial distress Signaling effects Incentive effects Event clientele effects
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Effect of Leverage on Firm Value
VLevered = Vunlevered + tD – CBankruptcy and Distress
tD: PV of debt tax shields tD: value effect of firm’s financing VUnlevered : PV of operating cash cash flows
As borrowing increases default risk will offset the value created by borrowing When borrowing is more default risk will more than offset the value created by
borrowing Value of CBankruptcy and Distress can be computed by..,
Debt market indications Differential value between two debt instruments
Put option valuation [may also use credit derivatives]
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Firm with Mismatched Debt
Firm Value
Value of Debt
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Firm with Matched Debt
Firm Value
Value of Debt
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Credit Rating and Key Financial Ratios
AAA AA A BBB BB BEBIT interest coverage (x) 23.4 13.3 6.3 3.9 2.2 1Funds from operations/ total debt (%) 214.2 65.7 42.2 30.6 19.7 10.4Free operating cash flow/ total debt (%) 156.6 33.6 22.3 12.8 7.3 1.5Return on capital (%) 35 26.6 18.1 13.1 11.5 8Operating income/ sales (%) 23.4 24 18.1 15.5 15.4 14.7LT debt/ capital (%) -1.1 21.1 33.8 40.3 53.6 72.6Total-debt/ capital, incl. Short-term debt (%) 5 35.9 42.6 47 57.7 75.1
Non-Investment GradeInvestment GradeKey Industrial Financial Ratios by Credit Rating
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Credit Rating and Firm ValueIllustration…
Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 1.27 9.57% AAA 5.15% 38.00% 3.19% 9.57% $5,59010% 1.36 9.92% AAA 5.15% 38.00% 3.19% 9.25% $6,11120% 1.46 10.36% A- 6.15% 38.00% 3.81% 9.05% $6,27230% 1.66 11.16% C 15.00% 27.08% 10.94% 11.09% $1,38840% 1.94 12.27% C 15.00% 20.31% 11.95% 12.14% $1,15950% 2.40 14.10% D 16.50% 10.66% 14.74% 14.42% $45360% 3.00 16.50% D 16.50% 8.88% 15.03% 15.62% $39870% 4.00 20.50% D 16.50% 7.61% 15.24% 16.82% $35580% 6.00 28.51% D 16.50% 6.66% 15.40% 18.02% $32090% 12.00 52.51% D 16.50% 5.92% 15.52% 19.22% $291
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Effect of Leverage on BetaIllustration
These inputs are absolutely essential to the calculation.
Enter the current beta of the company = 1.40
Enter the marginal tax rate for the company = 36%
Enter the average debt/equity ratio over the period of the regression = 14%
The following inputs are useful for the re-estimation of the beta, if the current D/E ratio is different from the average.
Enter the current market value of equity in the company = 50,889$
Enter the current book value of debt in the company = 12,342$
Enter the average maturity of the debt in the company = 5
Enter the interest expenses from the most recent 12 months = 876$
Enter the current market interest rate on this company's debt = 7.50%
Market Value of Debt = 12,142$
Enter the estimated debt value of the firm's operating leases
Output from the Analysis
Unlevered Beta for the firm (based upon average debt/equity ratio) = 1.28
Current Beta for the firm (based upon current debt/equity ratio) = 1.48
Debt to Capital Debt/Equity Ratio Beta Effect of Leverage
0.00% 0.00% 1.28 0.00
10.00% 11.11% 1.38 0.09
20.00% 25.00% 1.49 0.21
30.00% 42.86% 1.64 0.35
40.00% 66.67% 1.83 0.55
50.00% 100.00% 2.11 0.82
60.00% 150.00% 2.52 1.23
70.00% 233.33% 3.20 1.92
80.00% 400.00% 4.57 3.29
90.00% 900.00% 8.69 7.40
Customized Inputs
Enter the debt/equity ratio that you think the firm will have = 35%
Levered Beta based upon this debt/equity ratio = 1.57
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Effect of Leverage on BetaIllustration
47
Estimating Probability of DistressCoupon Rate = 12.00%Maturity of bond= 8Riskfree rate = 5.00%Market price of bond= $653.00
Year Cash Flow CF (1-) Present Value1 $120.00 $103.76 $98.822 $120.00 $89.72 $81.383 $120.00 $77.58 $67.024 $120.00 $67.08 $55.195 $120.00 $58.01 $45.456 $120.00 $50.16 $37.437 $120.00 $43.37 $30.828 $1,120.00 $350.00 $236.90
$0.00Value of bond = $653.00
Probability of distress (Annual) = 13.53%Probability of distress over 5 years = 51.66%Probability of distress over 10 years = 76.63%
To estimate the probability of distress1. Open solver (from tools)2. Set the value equal to the market price of bond3. Solve for the probability of distress
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Cost of Financial Distress
Elephant in the room No straight forward model exists to adjust beta estimates
for costs of financial distress Could estimate the present value of expected costs of
financial distress by assuming…, Financial markets will price them equivalently to an insurance policy or a
put option
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Cost of Financial DistressValuing Put Option
Price Must be the value of firm’s assets
Exercise price Face value of debt
Volatility Volatility of operating income
Since its not levered right now
share price volatility can be used
Life of option Term of debt
Risk free rate Should be contemporaneous with
the life of option
Dividend Valuing a put option on debt
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Cost of Financial Distress
Direct costs of Bankruptcy Lawyers and accountings
Cost of dividing up the pie - enforcement costs. Loss of PV of Tax Credits
Indirect costs of Bankruptcy On Sales and customers: Future Service and reliability. Large costs of switching suppliers Lost up-front relationship specific costs. On Firm Opportunities: Higher Supplier Charges / trade credit Cutback in R&D, advertising On Operating Costs: Higher Labor Costs / Higher costs of investing in long term relationship On Flexibility: Debt restrictions and covenants Expected(Costs) = Prob. of bankruptcy * Cost of Bankruptcy
Indirect costs are related to economic distress not bankruptcy. This is true for firms that enter bankruptcy.
Many avoid bankruptcy – restructure their debt quickly
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Causes of High Bankruptcy Costs
Higher bankruptcy cost causes..,Key employees jump shipSuppliers refuse to grant creditCustomer seek more stable suppliersLenders demand higher interest ratesImpose more restrictive loan covenants if potential
bankruptcies looms
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Deciding Financing Mix
Life Cycle Start- up firms: more equity Mature firms: more debt.
Comparable firms Debt ratio similar to comparable firms in the same business
Financing Hierarchy Retained earnings being the most preferred choice Work down the preference list, rather than picking a financing mix
directly
57
Optimal Financing Mix
The Operating Income Approach: In this approach, the optimal debt for a firm is chosen to ensure that the probability that the firm will default does not exceed a management-specified limit.
The Cost of Capital Approach: In this approach, the optimal debt ratio is chosen to minimize cost of capital, if operating cash flows are unaffected by financing mix, or to maximize firm value.
The Adjusted Present Value Approach: In this approach, the effect of adding debt to firm value is evaluated by measuring both the tax benefits and the bankruptcy costs.
The Return Differential Approach: In this approach, the debt ratio is chosen to maximize the difference between ROE and cost of equity
Comparables Approach: The debt ratio is chosen by looking at how comparable firms are funded
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Effect of New Debt
Share price will quickly and fully reflect the changes in investor’s perceptions because of…
Present value of new debt tax shields created by the recapitalization - Marginal tax rate times the value of debt outstanding
Present value of the costs of financial distress Signaling effect
Stock holders opinion on expectation of insiders Incentive effects
Bind management to deliver predictable operating results in order to service the debt
Clientele effects Investors may bail out of stock; allowing others to buy in
59
Debt Financing Disciplines Managers
Control on investing in risk projects Higher debt requirements forces manager to earn more to
service debt High debt payments in LBO force managers to conserve
cash by eliminating unnecessary expenditures More careful with shareholders money
60
Signal of Leveraged Recapitalization
Run out of profitable and internal investment opportunities Firm’s debt capacity would not be more profitably employed in financing new
investments…, Plant Equipment Acquisitions
Shares are undervalued (if debt used for buying back shares) Signal optimism on the part of managers and directors regarding future cash
flows, which suggest they will be sufficiently sizeable in the future to meet the burden of interest and principal payments
Commitment on the part of insiders not to divert the resources of the firm to other uses
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Implementing Capital Structure Change
Need to increase the debt incrementally May increase dividend payout Continuously engage in repurchases or acquisitions
Leveraging can be a good kick-off tactics for the management
Could be a vehicle for signaling the new management’s concern with the financial side of the business as well as producing visible gains in EPS and ROE
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Implementing Capital Structure Change
Adding debt by buying back stock selling at premium is less attractive…
– Benefits of added debt will be wiped out by the premium paid for buying back
Other alternatives Debt-for-securities swap Special dividend using add debt Adding debt through acquisitions… if the acquisition premium is low
64
Life Cycle and Financing Choices
Stage 2Rapid Expansion
Stage 1Start-up
Stage 4Mature Growth
Stage 5Decline
ExternalFinancing
Revenues
Earnings
Owner’s EquityBank Debt
Venture CapitalCommon Stock
Debt Retire debtRepurchase stock
External fundingneeds
High, but constrained by infrastructure
High, relative to firm value.
Moderate, relativeto firm value.
Declining, as a percent of firm value
Internal financing
Low, as projects dryup.
Common stockWarrantsConvertibles
Stage 3High Growth
Negative orlow
Negative orlow
Low, relative to funding needs
High, relative tofunding needs
More than funding needs
Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancingTransitions
Growth stage
$ Revenues/Earnings
Time
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Design the Perfect Financing Instrument
The perfect financing instrument will– Have all of the tax advantages of debt– While preserving the flexibility offered by equity
Duration Currency Effect of InflationUncertainty about Future
Growth PatternsCyclicality &Other Effects
Define DebtCharacteristics
Duration/Maturity
CurrencyMix
Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future
Straight versusConvertible- Convertible ifcash flows low now but highexp. growth
Special Featureson Debt- Options to make cash flows on debt match cash flows on assets
Start with the Cash Flowson Assets/Projects
Commodity BondsCatastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
66
Designing DebtDuration Currency Effect of Inflation
Uncertainty about Future
Growth PatternsCyclicality &Other Effects
Define DebtCharacteristics
Duration/Maturity
CurrencyMix
Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future
Straight versusConvertible- Convertible ifcash flows low now but highexp. growth
Special Featureson Debt- Options to make cash flows on debt match cash flows on assets
Start with the Cash Flowson Assets/Projects
Overlay taxpreferences
Deductibility of cash flowsfor tax purposes
Differences in tax ratesacross different locales
Consider ratings agency& analyst concerns
Analyst Concerns- Effect on EPS- Value relative to comparables
Ratings Agency- Effect on Ratios- Ratios relative to comparables
Regulatory Concerns- Measures used
Factor in agencyconflicts between stockand bond holders
Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts
Type of Assets financed- Tangible and liquid assets create less agency problems
Existing Debt covenants- Restrictions on Financing
Consider Information Asymmetries
Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt
Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt
If agency problems are substantial, consider issuing convertible bonds
Can securities be designed that can make these different entities happy?
If tax advantages are large enough, you might override results of previous step
Zero Coupons
Operating LeasesMIPsSurplus Notes
ConvertibilesPuttable BondsRating Sensitive
NotesLYONs
Commodity BondsCatastrophe Notes
Design debt to have cash flows that match up to cash flows on the assets financed
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Factors Affecting Capital Structure Decision
Company life stage Use of funds Capital market’s favor of the company Base assumptions Industry average norms Industry dynamics Shareholders objectives and preferences Agency cost Signaling cost Financial distress cost
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Financial Slack
Financial Slack can be defined as the amount of funds a firm has available to invest without visiting the external financial markets after paying interest and before paying dividends + Depreciation
The following factors influence whether firms should have more equity (financial slack) or more Debt in their capital structures..,
Firms Track Record of Picking Good Investments The likelihood of good investments and opportunities arising (growth industry?)
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Framework to Getting to the Optimal
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Capital Structure Theory
MM theory Zero taxes Corporate taxes Corporate and personal taxes
Trade-off theory Signaling theory Debt financing as a managerial constraint Pecking order theory
Retained Earnings Straight Debt Convertible Debt External Common Equity Straight Preferred Stock Convertible Preferred