Capital Structure: The Financing Details 05/21/08 Ch. 9

2 Capital structure changes If a firm’s debt ratio is different from its optimal debt ratio the firm has to decide whether to Move towards the optimal Move quickly or gradually

3 Should a firm change its capital structure? Reasons for maintaining a sub-optimal debt ratio: Underlevered firms Adding debt may add restrictions (through debt covenants) to what a firm can do. Firms that value flexibility may choose not to use their excess capacity Firms with greater uncertainty about future financing needs may also value flexibility Overlevered firms Government protection (from bankruptcy) may allow firms to stay overlevered without facing the costs of default

4 Gradual versus immediate change How confident is the firm about the optimal leverage estimate? How does the firm’s current debt ratio compare to that of the industry? For underlevered firms, What is the likelihood of takeover? Does the firm need financial flexibility? For overlevered firms, What is the likelihood of bankruptcy?

5 Implementing changes in financial mix Recapitalization – firms change their financing mix on current projects by using new equity to retire debt or new debt to reduce equity. This can be done by Borrowing money and buying back stock Conducting a debt-for-equity swap, where a firm replaces equity with debt of equivalent market value Issuing new equity and using the proceeds to pay off some of its outstanding debt

6 Implementing changes in financial mix Divestiture Selling firm assets and using the proceeds to reduce debt or equity. Firms will typically sell the worse performing assets for this purpose.

7 Implementing changes in financial mix Financing new investments Firms can change their debt ratio by financing new investments disproportionately with new debt or equity. This process will gradually change the debt ratio.

8 Implementing changes in financial mix Changing dividend payout Increasing the proportion of earnings paid out as dividends will increase the debt ratio.

9 Choosing between the alternatives Urgency of change Quality of new investments – does the firm have good projects that will allow them to alter their debt ratio? Marketability of existing investments – does the firm have assets that do not earn excess returns and that can be sold at a fair price?

10 A framework for analyzing a company’s capital structure Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Is the firm a takeover target? YesNo Does the firm have good projects? (Positive NPV) Yes Take good projects with new equity or with retained earnings. No 1. Pay off debt with retained earnings 2. Reduce or eliminate dividends 3. Issue new equity and pay off debt Yes No Does the firm have good Projects? Yes Take good projects with debt No Do your stockholders like dividends? Yes - Pay Dividends No - Buy back stock No – Recapitalization 1. Debt/equity swap 2. Borrow money, buy back shares Does the firm have marketable investments? No - Recapitalization : 1. Equity for debt swap 2. Renegotiate with lenders Yes - Divestiture Sell assets and retire debt Does the firm have marketable investments? Yes - Divestiture Sell assets and buy back stock