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Chapter 6

The Financing Decision

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FIGURE 6-1 Leverage Increases Risk and Expected Return

0.28 0.12 -0.04

0% 28% 12% -4%10% 30% 13% -5%20% 33% 14% -6%30% 35% 14% -6%40% 38% 15% -7%50% 40% 16% -8%60% 42% 17% -9%70% 45% 18% -10%80% 47% 18% -10%90% 50% 19% -11%

100% 52% 20% -12%110% 54% 21% -13%120% 57% 22% -14%130% 59% 22% -14%140% 62% 23% -15%150% 64% 24% -16%160% 66% 25% -17%170% 69% 26% -18%180% 71% 26% -18%190% 74% 27% -19%200% 76% 28% -20%210% 78% 29% -21%220% 81% 30% -22%230% 83% 30% -22%240% 86% 31% -23%

Leverage Increases Risk and Expected Return

Boom ROIC = 28%

Expected ROIC = 12%

Bust ROIC = -4%

-40%

-20%

0%

20%

40%

60%

80%

100%

120%

140%

0% 100% 200% 300% 400%

Financial leverage (debt/equity)

Ret

urn

on e

quity

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TABLE 6-1 Selected Information about Harbridge Electronix’s Financing Options in 2000 ($ millions)

Stock Financing Bond Financing

Interest-bearing debtoutstanding

$160 $460

Shareholders’ equity (bookvalue)

1,120 820

Interest expense 16 52

Principal payments 40 55

Common sharesoutstanding

65 50

Dividends paid 33 25

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TABLE 6-2 Harbridge Electronix Financial Obligations in 2000 ($ millions)

Stock Bonds

Aftertax Before Tax Aftertax Before Tax

Interestexpense

$16 $52

Principalpayment

$40 67 $55 92

Commondividends

33 55 25 42

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Harbridge Electronix Analysis of Coverage

Stock Bonds

Coverage

PercentageEBIT

Can Fall Coverage

PercentageEBIT

Can FallTimesinterestearned

18.8x 95% 5.8x 83%

Timesburdencovered

3.6 72 2.1 5.2

Timescommoncovered

2.2 55 1.6 38

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TABLE 6-3 Debt Ratios, 1992 - 1997 (numbers in parentheses are the number of companies in the Industry sample)

1992 1993 1994 1995 1996 1997Standard & Poor's 400 Industrials: Debt to total assets* (%) 20 19 20 20 20 20 Times interest earned 3.0 3.4 5.1 5.0 5.6 5.5 Aerospace/defense (4) Debt to total assets (%) 12 14 13 14 25 24 Times interest earned 5.8 7.1 6.2 4.4 4.9 9.3 Airlines (4) Debt to total assets (%) 35 34 36 32 23 21 Times interest earned (0.9) 0.2 0.5 2.0 3.4 6.4 Broadcasting (Television, Radio & Cable) (5) Debt to total assets (%) 57 47 45 43 46 43 Times interest earned 1.7 2.1 2.4 1.1 0.4 0.8

Continued

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TABLE 6-3 (Concluded) Debt Ratios, 1992 - 1997 (numbers in parentheses are the number of

companies in the industry sample)Computers (Hardware) (9) Debt to total assets (%) 13 16 14 10 10 17 Times interest earned (3.7) (4.1) 4.2 10.0 10.6 11.0 Electronics (Semiconductors) (6) Debt to total assets (%) 9.0 7.0 6.0 7.0 9.0 4.8 Times interest earned 9.8 21.0 24.7 34.4 32.1 35.6 Hardware & Tools (2) Debt to total assets (%) 32 31 27 26 26 29 Times interest earned 1.9 3.0 3.3 3.1 3.5 2.0

* Interest-bearing debt.

Source: Standard and Poor's Analysts Handbook, 1998 Annual Edition. Reprinted by permission ofStandard & Poor's, a division of The McGraw-Hill Companies, Inc. Companies in selected industries arethose firms represented in the Standard & Poor's 500 stock averages. Generally, they are among thelargest companies in the industry.

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TABLE 6-4 Median Value of Key Ratios by Standard & Poor’s Rating Category (industrial long-term debt, three-year figures, 1996 - 1998

AAA AA A BBB BB B CCCTimes interest earned (X) 12.9 9.2 7.2 4.1 2.5 1.2 (0.9) EBITDA interest coverage (X) 18.7 14.0 10.0 6.3 3.9 2.3 0.2 Funds from operations/total debt (%) 89.7 67.0 49.5 32.2 20.1 10.5 7.4 Pretax return on permanent capital (%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8) Long-term debt/capital (%) 21.4 29.3 33.3 40.8 55.3 68.8 71.5

Note: These figures are not meant to be industry standards.

Source: "Adjusted Key U.S. Industrial Financial Ratios," Standard & Poor's CreditWeek, July 28,1999, p.16. Also available at www.standardpoor.com/ratings/corporates/index.htm. Reprinted by permission ofStandard & Poor's, a division of The McGraw-Hill Companies, Inc.

See text for variable definitions

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TABLE 6-5 Harbridge Electronic Partial Pro Forma Income Statements in 2000 under Bust and Boom Conditions ($ millions except EPS)

Stock Bonds Stock BondsEBIT $100 $100 $500 $500Interest expense 16 52 16 52

Earnings before tax 84 48 484 448 Tax at 40% 34 19 194 179

Earnings aftertax $50 $29 $290 $269

Number of shares (millions) 65 50 65 50 Earnings per share $0.77 $0.58 $4.46 $5.38

Return on invested capital 5.4% 5.4% 26.8% 26.8%Return on equity 4.5% 3.5% 25.9% 32.8%

Bust Boom

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FIGURE 6-2 Range of Earnings Chart for Harbridge Electronix

-$1.00

$0.00

$1.00

$2.00

$3.00

$4.00

$5.00

$6.00

$7.00

$0 $100 $200 $300 $400 $500 $600

Earnings before interest and taxes (EBIT) ($ millions)

Ear

ning

s pe

r sha

re (E

PS

)

Bus

t EB

IT

Expe

cted

EB

IT

Boo

m E

BIT

Crossover pointEBIT = $172 million

Bondfinancing

Stockfinancing

14%

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TABLE 6A-1 In the Absence of Taxes, Debt Financing Affects Neither Income nor Firm Value, in the Presence of Taxes, Prudent Debt Financing Increases Income and Firm Value

Timid Inc. Bold Co. Timid Inc. Bold Co.

EBIT 400$ 400$ 400$ 400$ Interest expense 0 80 0 80

Earnings before tax 400 320 400 320Corporate tax 0 0 160 128

Earnings aftertax 400$ 320$ 240$ 192$

Investment 1,000$ 200$ 1,000$ 200$ Rate of return 40% 160% 24% 96%

Corporate Taxes

at 40%

Corporate Income

No Taxes

Continued

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TABLE 6A-1 (Concluded) In the Absence of Taxes, Debt Financing Affects Neither Income nor Firm Value,

in the Presence of Taxes, Prudent Debt Financing Increases Income and Firm Value

Timid Inc. Bold Co. Timid Inc. Bold Co.

Dividends received 400 320 240 192Interest expense 80 0 80 0

Income 320$ 320$ 160$ 192$

Equity invested 200$ 200$ 200$ 200$ Rate of return 160% 160% 80% 96%

Income before tax 160 192Personal taxes 53 63

Income aftertax 107$ 129$

Equity invested 200$ 200$ Rate of return 54% 64%

Corporate Taxes

at 40%

Personal Taxes at 33%

Personal Income

No Taxes