The Financing Decision Chapter Six

1. Choices

a. If a firm requires $200 million in external financing, should it issue new debt or new equity?

The magic question.

What is the answer?

DEPENDs

b. What should we be thinking about?

Do not assume there is a single right answer to any of these questions.

OPM is other people’s money.

How does OPM affect:

risk-return relationships

taxes

financial distress?

signaling effects?

What is signaling? We will discuss later

2. Financial Leverage

Magnifying impact

Physical definition of a lever

Financial leverage is like that, using increased risk to amplify expected return.

3. Example

What is the average return prior to the change in debt?

After?

can we explain this with a story of increasing debt and sharing with investors.

4. The Bottom Line

Increased debt lowers the initial investment required by shareholders.

Increased debt amplifies the expected return.

Increased debt amplifies the risk faced by shareholders.

That’s what financial leverage is all about.

5. What is business risk?

Operating leverage, featuring high fixed costs, but low variable costs, works the same way.

Each business has a level of risk based on the way the business is run.

I use an example of digging ditches.

You can do the job manually

Limited profits and no losses possible (all variable costs)

We can lease machines

Fixed costs added

Increase both profit potential and losses

6. Key Equation

a. ROE = ROIC + (ROIC – i’) (D/E)

i. Notice that for an unlevered firm, ROE is just ROIC.

ii. Leverage modifies ROIC, where the modification is proportional to D/E.

7. Favorable and Unfavorable Outcomes

a. ROIC < i’ is not good for a company since its assets generate a return that does not cover the after-tax cost of debt.

b. ROIC > i’ in favorable events, in which case ROE > ROIC.

c. ROIC < i’ in unfavorable events, in which case ROE < ROIC.

8. Sensient Technologies

Stable, conservatively financed, cash surplus, mediocre performance

Paying down debt

Hypothetical opportunity new acquisition

How to finance acquisition:

Debt leverage boosts ROE

9. Leverage and Risk

10. Look at 3 coverage ratios, involving the payment of interest, principal, and dividends, where coverage is for 1, top 2, or all 3 payments.

a. % EBIT Can Fall

i. When a coverage ratio drops below 1.0, the company is in danger of not being able to make its payments from operating cash flows.

ii. Ask by what % can EBIT fall before a ratio drops to 1.0

iii. The larger the % EBIT can drop, the less risk the company faces.

iv. Consider how debt financing impacts % that EBIT can fall.

What can we say about Sensient?

11. Compare With Industry Figures

12. How do the firm’s ratios stack up against the industry data?

13. How Much to Borrow?

a. What level of debt financing is best for a firm?

b. M&M’s irrelevance principle in the absence of taxes and transaction costs, firm’s debt levels do not impact value.

c. Total cash flows generated over time are the basis for the firm’s value.

d. The debt-equity split only determines how this value is apportioned between holders of debt and holders of equity.

Let’s say that a company wants to pay you $100. They need to decide whether to call the payment a dividend or interest.

Assume there are no taxes. No personal and no corporate.

Would you care what they called it?

Would they?

If no one cares, how would a change impact value?

14. Real World Issues

a. Taxes and transaction costs are part of the real world.

If there are corporate taxes, would your answers change?

If there were personal taxes, would they change?

15. What are the various items to take into consideration when making decisions about financing with debt or equity?

a. Higgins 5 factor model.

b. Tax Benefits

Interest is tax deductible.

Lowering the tax bill leaves more left over for all investors, meaning the pool of shareholders and debtholders.

c. Distress Costs

Increased debt leads to higher expected costs associated with financial distress.

Bankruptcy costs debt can turn a mild inconvenience into a major problem involving:

major legal expenses, and/or

the sale of company assets at fire sale prices.

d. Assets

Can assets be sold off, leaving a reasonable amount for shareholders of the bankrupt entity?

It depends on the assets.

Are they hard or soft?

Do they walk out the door at the end of the day?

e. Indirect Costs

Indirect costs come in many forms:

Lost profit opportunities from cutbacks to R&D

Lost sales as customers bail, fearing difficulties down the line, or suppliers bail out for fear that the firm won’t pay its bills

16. Conflicts of Interest

a. When times are rough and bankruptcy looks like it’s just around the corner, it might be reasonable for a firm to “go for broke.”

b. If “go for broke” fails, debtholders will pick up the tab.

c. If the “go for broke” works, equity holders benefit and bankruptcy is averted.

d. This behavior was part of the S&L crisis in the 1980s.

17. Summary Checklist

a. When making financing choices, keep the following in mind:

i. The ability of the company to use additional interest tax shields over the life of the debt.

ii. The increased probability of bankruptcy stemming from added leverage.

iii. The cost to the firm if bankruptcy occurs.

18. Issue Debt or Restrict Growth?

a. Remember that g* = PRAT, where T is based on prior shareholders’ equity.

b. Therefore, the firm faces a tradeoff, since issuing less debt and paying additional dividends to shareholders will lower growth.

WHAT DO THE VARIABLES STAND FOR?

19. What is the Prudent Thing to Do?

Financial managers should recognize the true risks they confront, and balance the benefits of higher leverage against the costs of higher leverage.

Too high a T will heighten the risk that critical management decisions will fall into the hands of creditors, who have interests of their own.

20. Market Signaling

a. When companies announce that they intend to raise new equity, their stock prices drop.

WHAT CUASES THIS?

When would a person ever sell a stock? When they think that the stock price is at the peak and cannot go higher.

This stand for when managers issue stocks.

They know that the stock price is at the top, on its way down.

How? Inside information.

21. Pecking Order

a. Managers might respond with a “pecking order” rule.

b. They fund new projects with cash, before turning to external sources.

c. If they fund externally, they fund first with debt.

d. They use equity only as a last resort.