The Ten-Day MBA 4th Ed. Page 21

  Long-term leases are, in substance, ways of financing a purchase, rather than buying the temporary services of a piece of equipment. Such long-term leases are called capital leases. The useful life of the leased equipment is used up by the lessee, and at the end of the lease the equipment usually stays with the lessee for a bargain purchase price like $1. The accountants have specific rules that deal with the different kinds of leasing arrangements. For capital leases, the leased assets and the financing liability are recorded on the leasing company’s books as though the company had bought the equipment outright.

  Bank Financing. The next level of financing involves banks. Banks can loan money for long or short periods of time. If a company has a credit line or revolver with a bank, it draws down and pays back up to set limits of credit as cash is needed and generated by the business. The credit is often secured by the assets of the firm. If a business runs into trouble, it may not be able to pay the bank and go into bankruptcy.

  When banks or investment analysts extend credit in the form of a loan or bond, they consider the 5C’s of credit.

  Cash flow—Are the cash flows enough to cover debt payments?

  Collateral—Is there enough collateral to repay the loan?

  Conditions—Are general economic conditions favorable for repayment?

  Course—Is the borrower headed on a good strategic course?

  Character—Is management qualified and morally inclined to honor repayment?

  Bond Issuance. Bonds have fixed-interest-rate contractual payments and a principal maturity. The risk to the firm’s owners comes if they cannot be serviced. In 1990 the Southland Corporation (7-Eleven stores) defaulted on its bond payment, and Ito-Yokado Corporation, the majority bondholder, exchanged its bonds for the ownership of the company and ousted the Thompson family from the company they had founded.

  The After-Tax Cost of Borrowing. Interest payments for borrowing from vendors, bankers, or bondholders are tax-deductible, while dividends to shareholders are not. The after-tax cost of borrowing is the interest cost less the tax benefit.

  After-Tax Cost of Borrowing = Borrowing Rate × (1 − Tax Rate)

  The Caterpillar bond used in the earlier example continued to pay 8 percent interest on the issue maturing in 2001. In 1999 Caterpillar’s corporate tax rate was projected at 34 percent. By deducting the interest expense on the tax returns, the company received, in effect, a 34 percent discount on its borrowing. The after-tax rate was 5.28 percent: 8% × (1 − .34).

  As you learned in the accounting chapter, dividends are not tax-deductible, but interest payments are. That difference is an incentive for businesses to borrow rather than issue stock and pay dividends. This phenomenon is called a tax shield for borrowing. In the leveraged buyout binge of the 1980s, the tax shield was a spur to borrow huge amounts, such as the $26.4 billion Kohlberg Kravis Roberts borrowed to buy RJR Nabisco in 1989. That year the government subsidized this venture to the tune of approximately $800 million (26.4 × 10% × 30%). Not surprisingly, many taxpayers favor eliminating or restricting the tax subsidy for interest expenses.

  Stock Issues. Stock issues have noncontractual, non-tax-deductible dividend payments. Stock represents an ownership interest in the business and in all of its assets. If additional shares of stock are issued to raise cash, this is done at the expense of the current shareholders’ ownership interest. New shareholders share their ownership interest equally on a per-share basis with the current shareholders. That is why analysts say that the new shares dilute the interest of existing shareholders.

  Several markets are available to sell new stock issues: the New York Stock Exchange (NYSE) and the National Association of Securities Dealers Automated Quotations System (NASDAQ). When a stock is not listed on an exchange, but is publicly traded, it is traded over the counter (OTC). If a company’s shares are not publicly traded, the company is said to be privately held.

  Financial advisers called investment bankers assist in the sale of new shares in companies. Noted investment bankers such as Goldman Sachs Group and Morgan Stanley, employing many MBAs, work on these initial public offerings (IPOs) for large fees. These I-bankers assist in the preparation of the selling documents, called the prospectus. The prospectus outlines the issuer’s history and business plans. The Securities Act of 1933 governs the disclosures required in this document.

  The Financing Mix’s Risk and Reward. The financing decisions in a corporation revolve around what is the best mix of debt and equity. That mix is called a company’s capital structure policy. When managers make large changes in the debt-to-equity mix, they call it restructuring.

  Theoretically, there is an optimal mix of debt and stock; however, there are no magic MBA formulas to establish that perfect ratio. MBAs can look to what worked in the past and to the mix of successful competitors. If the industry is cyclical, lighter debt loads are preferable in order to survive downturns. Good financial managers don’t decide on a financing plan and forget it. Capital structures are dynamic. Decisions to shift the balance from equity to debt and back again should be continually reviewed to make sure the capital structure is appropriate at any given time.

  Although there are no handy MBA formulas to solve once and for all the debt-versus-equity conundrum, there is a useful MBA acronym, FRICTO, whose initials stand for a useful checklist in sorting out capital structure issues.

  Flexibility. How much financial flexibility does management need to meet unforeseen events, such as new competitors or lawsuits? For example, Dow Corning never planned for the breast implant litigation that crippled the company.

  Risk. How much risk can management live with to meet foreseen events, such as downturns in the business cycle, strikes, and material shortages? Toy companies are known to produce hot toys that turn cold. Savvy managers should plan for the eventual sales drop-off by providing enough financial flexibility to survive the downturn. Accordingly, most toy companies have low debt-to-equity ratios.

  Income. What level of interest or dividend payments can earnings support? Financial managers are required to forecast the results of operations to determine cash flows. Using those forecasts, and the degree of confidence a manager has in his or her projections, he or she can determine what level of payments the company can make.

  Control. How much stock ownership does management want to share with outside investors? Many family business owners are leery of letting an outsider even know their income, let alone have a vote.

  Timing. Does the debt market offer attractive rates? Has the market overvalued the firm’s shares in the opinion of management? If so, then it makes sense to sell shares to the public. Conversely, if the stock is too cheap, then it is better to buy back shares from the public. After the crashes of 1987 and 2008, many firms took the opportunity to buy back their own shares. By reducing the number of shares outstanding, their share of debt financing grew as a portion of their capital structures.

  In 1991 investors could not buy enough biotechnology stock. They paid high prices for even questionable start-ups. Smart managers tapped that market and sold shares to the eager public at high prices. In 1992, the days of easy money ended when biotech fell out of favor with investors. The same story repeated itself for Internet companies in 1995 until the meltdown in 2000. And again more recently, the real estate bubble peaked in 2006 and started to unravel in 2007. A company’s capital structure should be dynamic to take advantage of market conditions.

  Other. Many other factors affect the paths managers take. At times, a company just can’t find a bank to lend money, forcing an equity choice. In other circumstances interest rates are just unaffordable, forcing an equity choice. The reasons for capital structure decisions are many.

  Key to financial structure is the discussion of ratios. In the accounting chapter, I explained the concept of financial leverage. Companies that maintain high levels of debt and little equity leverage their earnings for shareholders if there are profits. There are simply fewer shares to divide income by, y
ielding higher earnings per share. Conversely, highly leveraged firms wipe out the entire value of their equity when earnings falter and interest payments eat up all the profits.

  Managers of highly leveraged firms must decide whether it is worthwhile to risk bankruptcy if their cash flow projections don’t pan out in order to offer high returns to their shareholders. The Thompson family guessed wrong with Southland. Maybe if the Thompsons had used FRICTO, they might have avoided their losses?

  The market value of shares already issued is also related to the risk of a firm’s capital structure. If investors believe that debt levels are excessive, then they will pay less for the company’s shares, since the debt payments could put earnings in jeopardy. Investors will also discount the market value of a company’s debt for risk. That was the case in the early 1990s with leveraged companies such as Black & Decker, and RJR Nabisco. Many investors felt uncomfortable with the riskiness of their capital structures and avoided both the debt and equity of these highly leveraged companies.

  Modigliani and Miller, a famous duo from MBA academia, created a series of “propositions” that discussed how debt affects the values of firms. In 1958, Franco Modigliani and Merton Miller did their pioneering work on the effect of debt financing with and without a tax advantage. In a perfect world, the more debt the better. The value of the firm increases with higher debt levels. However, in the real world, as seen in the previous paragraph, investors do consider the risk of insolvency in their valuations of both debt and equity.

  OPTIMAL CAPITAL STRUCTURE

  The Cost of Capital

  OPTIMAL CAPITAL STRUCTURE

  The Value of the Firm and the Weighted Average Cost of Capital

  To summarize, the higher the percentage of debt to total capital, the higher a company’s value, to a point. At the point where the risk of bankruptcy becomes significant, values fall. The cost of financing decreases as a company adds lower-cost tax-shielded debt to displace the higher returns required by equity investors. But like stockholders, debt holders become nervous at a certain point and require higher rates of return to compensate them for their risk. Study the two graphs above that illustrate the workings of capital structure.

  A Detailed Capital Structure Decision Example. Although choosing the optimal capital structure is difficult, financial managers try to put together some numbers to make choices. If you are curious about the details and want to graduate from the Ten-Day MBA “cum laude,” read on. If not, just skip to the next section, about “Dividend Policy.” Making capital structure decisions involves a two-step process:

  1. Calculate the WACC.

  2. Value the free cash flows of the company, the value of the firm.

  The first step is to calculate the weighted average cost of capital (WACC) of the entire firm by using the following formula and calculating a number of variables. The cost of equity (Ke) is the most difficult.

  Review the formula. Notice that the WACC uses the market values of debt and equity. The market is the true measure of how current bondholders and shareholders value their investments. The cost of debt can be obtained from the company’s treasury department or can be found in the footnotes of the financial statements. It takes large boosts in debt financing to change the cost of debt. However, the cost of equity is a bit more complex to figure out.

  The cost of equity heavily depends on the leverage of the firm. Because leverage means risk, we can use beta from the capital asset pricing model (CAPM). The CAPM helps calculate the required return on equity under different leverage scenarios.

  Ke = Rf + (Km − Rf) × Beta

  (Km − Rf) = Risk Premium

  The risk measure, beta, changes according to the risk of leverage. Financial MBAs take the current levered beta and unlever it to a no-debt, unlevered state (Step A), then lever it back up to any hypothetical capital structure (Step B).

  To illustrate: The treasurer of Leverco, Inc., wants to decide whether to choose a 0 percent, 25 percent, or 50 percent debt capital structure. To do so, he has laid out the facts and calculations in the following columns of numbers. The conclusion is the Leverco should have a 50 percent debt / 50 percent equity capital structure. That’s the structure that maximizes the value of the firm while minimizing the WACC.

  Adapted from “An Introduction to Debt Policy and Value,” Case UVA-F-811. Copyright © 1989 by the Darden Graduate Business School Foundation, Charlottesville, Virginia.

  The same calculations demonstrated in Leverco’s case were used to derive the two theoretical graphs of the “Optimal Capital Structure.” The first is the calculation of the weighted average cost of capital. The second graph, using the lowest WACC shown, describes the maximum value of the firm. If you wish, you can try to recompute the calculations that are noted with an asterisk (*). These are the same computations that MBAs throughout the world use for capital structure decisions.

  Dividend Policy. Financial managers must decide how much of a firm’s profits should be paid out as dividends and must determine the size of dividends per share. This is called dividend policy.

  To guide them in their policies, financial managers use at least two measures—dividend yields and dividend payout ratios. The market plays a big role in determining the dividend yield since it is derived by dividing the annual dividend payment by the current share price. Dividends may also be paid out as a certain percentage of earnings, called the dividend payout ratio.

  Dividends are extremely important because they show clearly the cash-generating ability of the firm. Many analysts value companies based on the dividend cash flows. You saw that valuation method with the Dividend Growth Model earlier in this chapter.

  Investors love stable, steadily growing dividends and hate any cuts. Therefore, managers try to avoid swings in dividend payouts at all costs. If an MBA miscalculates the ability of the company to maintain a dividend his or her job will be in real jeopardy.

  There are five questions that astute MBAs ought to mull over as they formulate a policy that may directly affect their careers.

  Can the company do a better job by investing its earnings back into the firm than investors could by investing elsewhere? If a company is growing and has many exciting investment opportunities, dividends should be small and earnings should be used internally. In 2004, Wal-Mart paid a $.52 dividend per share against $2.15 in earnings, a 24 percent payout ratio, but investors were happy because the company was busy investing in many new and profitable stores. Its dividend yield was 1 percent of the $54 stock price. In the case of Microsoft, investors were upset that Microsoft was amassing billions in cash that it couldn’t effectively deploy as its sales growth slowed. Microsoft responded in 2003 with its first annual dividend of $.16 per share. In 2004, Microsoft doubled the annual dividend to $.32 per share and declared a special onetime dividend of $3 a share or $32 billion total, the largest corporate dividend distribution in history.

  Who is your stockholder? Do widows and orphans depend on your dividends for their incomes? This is the case with utility stocks, but not with start-up Internet companies.

  What will stockholders’ reaction be to any changes in dividend payments? Changes in dividend payments are a powerful signal to investors. Investors react violently to any cuts in dividends, since they signal that the company is in trouble. Increases are not such a big deal. More often than not, dividend increases are expected and greeted with little fanfare. Increases in dividends show management’s confidence that the business’s earnings are strong enough over the long term to sustain an increased payout.

  What is the degree of financial leverage of the company? To ensure that dividends will not be interrupted, companies should see to it that they can comfortably pay the dividends investors expect and demand.

  What is the growth strategy of the company? Growth companies usually pay little to no dividends. They need cash to finance their own growth. Biotechnology companies, for example, retain all their cash to support long-term research needs.

  If a c
ompany is strapped for cash and yet still wants to make investors happy, it can pay a stock dividend. This is a dividend that the company pays in shares of the company, not cash. Such dividends usually range from 2 to 5 percent of shares owned. For example, if you owned one hundred shares, you would receive two to five new shares. Investors end up with a greater number of shares, but since all shareholders receive the same percentage share dividend, their percentage ownership of the firm remains the same.

  If a stock price is high, the company can also have a stock split, giving two or three shares for every share owned. It makes the stock more affordable and makes investors happy, but the percentage ownership remains the same.

  MERGERS AND ACQUISITIONS

  Mergers and acquisitions (M&A) is one of the most exciting areas of finance. The same investment bankers who help companies raise money also help companies spend it. Many highly paid MBAs work in this field. “Strategic” reasons and methods for M&A are covered in the strategy chapter. This chapter will cover the legitimate financial reasons for mergers and acquisitions.

  Diversify the Company

  Many companies attempt to lower risk by owning other businesses. Philip Morris renamed itself Altria and bought Kraft, General Foods, and Miller Brewing because it wanted to diversify. Tobacco usage was declining, lawsuits loomed, and new regulation limiting advertising was pending. Altria has since spun off those companies and bought UST to concentrate solely on tobacco.