The Financing Mix and Choices

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• The Financing Mix and Choices

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Financing Choices

• A firm that decides to move from its current debt
  level to its optimal financing mix has two
  decisions to make.
• It has to consider how quickly it wants to move.
• How to increase or decrease the debt ratio
• To recapitalizing the investments
• To divest assets and use the cash to reduce debt
  or equity
• To invest in new projects with debt or equity
• To change the dividend policy
• The choice of financing should be determined
  largely by the nature of the cash flows on its
  assets.
• Matching financing choices to asset
  characteristics decreases default risk for any
  given level of debt, and allows the firm to
  borrow more.

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To Change or Not to Change

• Underlevered firms may have a number of reasons
  for choosing not to use their excess capacity.
• Alternatives objectives
• Maximize net income
• Maintain a high bond rating
• The debt comes with covenants that restrict what
  the firm can do in the future.
• To maintain the financing flexibility
• The likelihood of bankruptcy that comes with debt
  mat be weighted disproportionately in making the
  decision to borrow.
• There might be reasons for overlevered not to
  reduce the debt.
• Government guarantee

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Gradual versus Immediate Change

• For underlevered firms, the decision to increase
  the debt ratio to the optimal either quickly or
  gradually is determined by four factors.
• Degree of confidence in the optimal leverage
  estimate
• Comparability to industry
• Likelihood of a takeover
• Need for financial flexibility

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Implementing Changes in Financing Mix

• Recapitalization
• To use new equity to retire debt or new debt to
  reduce equity
• The simplest and the quickest way
• Divestiture and Use of Proceeds
• To sell assets and use the cash they receive from
  the divestiture to reduce debt or equity
• Firms usually want to divest the investments that
  are earnings less than their required returns.
• Financing New Investments
• To finance new investments disproportionately
  with debt or equity.
• Changing Dividend Payout

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Choosing among the alternatives

• Urgency with which the firm is trying to move to
  its optimal debt ratio
• Recapitalizations and divestitures can be
  accomplished in a few weeks and can change debt
  ratios significantly.
• Financing new investments or changing dividend
  payout is along-term strategy to change debt
  ratios.
• Quality of new investments
• Firms with good investments will gain more by
  financing these new investments with new debt if
  the firm is underlevered or with new equity if
  the firm is overlevered.
• Using debt capacity or new equity to invest in
  poor projects is a bad strategy since the
  projects will destroy value.
• Marketability of existing investments
• Whether existing investments earn excess returns
• Whether divesting these assets will generate a
  price high enough to compensate the firm for the
  cash flows lost by selling them.

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A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser
than the optimal debt ratio?
Actual gt Optimal
Actual lt Optimal
Overlevered
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes
No
Yes
No
Reduce Debt quickly
Increase leverage
Does the firm have good
Does the firm have good
1. Equity for Debt swap
quickly
projects?
projects?
2. Sell Assets use cash
1. Debt/Equity swaps
ROE gt Cost of Equity
ROE gt Cost of Equity
to pay off debt
2. Borrow money
ROC gt Cost of Capital
ROC gt Cost of Capital
3. Renegotiate with lenders
buy shares.
Yes
No
Yes
No
Take good projects with
1. Pay off debt with retained
Take good projects with
new equity or with retained
earnings.
debt.
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
Do your stockholders like
dividends?
debt.
Yes
No
Pay Dividends
Buy back stock
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The Home Depot Applying the Framework
Is the actual debt ratio greater than or lesser
than the optimal debt ratio?
Actual gt Optimal
Actual lt Optimal
Overlevered
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes
No
Yes
No
Reduce Debt quickly
Increase leverage
Does the firm have good
Does the firm have good
1. Equity for Debt swap
quickly
projects?
projects?
2. Sell Assets use cash
1. Debt/Equity swaps
ROE gt Cost of Equity
ROE gt Cost of Equity
to pay off debt
2. Borrow money
ROC gt Cost of Capital
ROC gt Cost of Capital
3. Renegotiate with lenders
buy shares.
Yes
No
Yes
No
Take good projects with
1. Pay off debt with retained
Take good projects with
new equity or with retained
earnings.
debt.
earnings.
2. Reduce or eliminate dividends.
Do your stockholders like
3. Issue new equity and pay off
dividends?
debt.
Yes
No
Pay Dividends
Buy back stock
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6 Application Test Getting to the Optimal

• Based upon your analysis of both the firms
  capital structure and investment record, what
  path would you map out for the firm?
• Immediate change in leverage
• Gradual change in leverage
• No change in leverage
• Would you recommend that the firm change its
  financing mix by
• Paying off debt/Buying back equity
• Take projects with equity/debt

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Designing Debt The Fundamental Principle

• To examine the cash flow characteristics of the
  assets or projects that will be financed.
• The objective in designing debt is to make the
  cash flows on debt match up as closely as
  possible with the cash flows that the firm makes
  on its assets.
• By doing so, we reduce our risk of default,
  increase debt capacity and increase firm value.

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Firm with mismatched debt
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Firm with matched Debt
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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

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Ensuring that you have not crossed the line drawn
by the tax code

• All of this design work is lost, however, if the
  security that you have designed does not deliver
  the tax benefits.
• In addition, there may be a trade off between
  mismatching debt and getting greater tax
  benefits.

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While keeping equity research analysts, ratings
agencies and regulators applauding

• Ratings agencies want companies to issue equity,
  since it makes them safer. Equity research
  analysts want them not to issue equity because it
  dilutes earnings per share. Regulatory
  authorities want to ensure that you meet their
  requirements in terms of capital ratios (usually
  book value). Financing that leaves all three
  groups happy is nirvana.

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Soothe bondholder fears

• There are some firms that face skepticism from
  bondholders when they go out to raise debt,
  because
• Of their past history of defaults or other
  actions
• They are small firms without any borrowing
  history
• Bondholders tend to demand much higher interest
  rates from these firms to reflect these concerns.

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And do not lock in market mistakes that work
against you

• Ratings agencies can sometimes under rate a firm,
  and markets can under price a firms stock or
  bonds. If this occurs, firms should not lock in
  these mistakes by issuing securities for the long
  term. In particular,
• Issuing equity or equity based products
  (including convertibles), when equity is under
  priced transfers wealth from existing
  stockholders to the new stockholders
• Issuing long term debt when a firm is under rated
  locks in rates at levels that are far too high,
  given the firms default risk.

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Designing Debt Bringing it all together
Start with the
Cyclicality
Cash Flows
Growth Patterns
Other Effects
Duration
Currency
Effect of Inflation
on Assets/
Uncertainty about Future
Projects
Fixed vs. Floating Rate
Straight versus
Special Features
Commodity Bonds
More floating rate
Convertible
on Debt
Catastrophe Notes
Duration/
Currency
Define Debt
- if CF move with
- Convertible if
- Options to make
Maturity
Mix
Characteristics
inflation
cash flows low
cash flows on debt
- with greater uncertainty
now but high
match cash flows
on future
exp. growth
on assets
Design debt to have cash flows that match up to
cash flows on the assets financed
Deductibility of cash flows
Differences in tax rates
Overlay tax
Zero Coupons
for tax purposes
across different locales
preferences
If tax advantages are large enough, you might
override results of previous step
Consider
Analyst Concerns
Ratings Agency
Regulatory Concerns
ratings agency
Operating Leases
- Effect on EPS
- Effect on Ratios
- Measures used
analyst concerns
MIPs
- Value relative to comparables
- Ratios relative to comparables
Surplus Notes
Can securities be designed that can make these
different entities happy?
Observability of Cash Flows
Type of Assets financed
Existing Debt covenants
Convertibiles
Factor in agency
by Lenders
- Tangible and liquid assets
- Restrictions on Financing
Puttable Bonds
- Less observable cash flows
create less agency problems
conflicts between stock
Rating Sensitive
lead to more conflicts
and bond holders
Notes
LYONs
If agency problems are substantial, consider
issuing convertible bonds
Consider Information
Uncertainty about Future Cashflows
Credibility Quality of the Firm
Asymmetries
- When there is more uncertainty, it
- Firms with credibility problems
may be better to use short term debt
will issue more short term debt
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Approaches for evaluating Asset Cash Flows

• I. Intuitive Approach
• Are the projects typically long term or short
  term? What is the cash flow pattern on projects?
• How much growth potential does the firm have
  relative to current projects?
• How cyclical are the cash flows? What specific
  factors determine the cash flows on projects?
• II. Project Cash Flow Approach
• Project cash flows on a typical project for the
  firm
• Do scenario analyses on these cash flows, based
  upon different macro economic scenarios
• III. Historical Data
• Operating Cash Flows
• Firm Value

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Coming up with the financing details Intuitive
Approach - The Home Depot

• Historically, the Home Depots typical project
  has been a new home-improvement products store of
  roughly 100,000 square feet, with a fairly long
  life and a substantial real estate investment.
• The construction of the store takes a relatively
  short time (1-2 years), and the stores start
  generating cash flows immediately.
• In addition, most of the growth for the firm
  since its inception has come from the United
  States.

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The Home Depot The Right Debt

• It should be long term, with a life roughly
  matching the life of the store.
• The debt should have a fixed rate or fixed
  payments each year, because the stores start to
  generate cash flows immediately and there is an
  absence of pricing power in this business. If the
  Home Depot had more pricing power, it could
  consider using floating rate debt, since cash
  flows are more likely to move with inflation.
• The debt should be in U.S. dollars, at least for
  new stores in the United States.
• If possible, the value of the debt should be tied
  to the value of the real estate underlying the
  store

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6 Application Test Choosing your Financing Type

• Based upon the business that your firm is in, and
  the typical investments that it makes, what kind
  of financing would you expect your firm to use in
  terms of
• Duration (long term or short term)
• Currency
• Fixed or Floating rate
• Straight or Convertible

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Quantitative Approach

• 1. Operating Cash Flows
• The question of how sensitive a firms asset cash
  flows are to a variety of factors, such as
  interest rates, inflation, currency rates and the
  economy, can be directly tested by regressing
  changes in the operating income against changes
  in these variables.
• Change in Operating Income(t) a b Change in
  Macro Economic Variable(t)
• This analysis is useful in determining the
  coupon/interest payment structure of the debt.
• 2. Firm Value
• The firm value is clearly a function of the level
  of operating income, but it also incorporates
  other factors such as expected growth cost of
  capital.
• The firm value analysis is useful in determining
  the overall structure of the debt, particularly
  maturity.

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Historical Data
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Sensitivity to Interest Rate Changes

• The answer to this question is important because
  it
• it provides a measure of the duration of the
  firms projects
• it provides insight into whether the firm should
  be using fixed or floating rate debt.

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Firm Value versus Interest Rate Changes

• Regressing changes in firm value against changes
  in interest rates over this period yields the
  following regression
• Change in Firm Value 0.51 - 7.49 ( Change in
  Interest Rates)
• (2.68) (0.46)
• T statistics are in brackets.
• Conclusion The duration (interest rate
  sensitivity) of The Home Depots asset values is
  about 7.49 years. Consequently, its debt should
  have at least as long a duration.

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Why the coefficient on the regression is
duration..

• The duration of a straight bond or loan issued by
  a company can be written in terms of the coupons
  (interest payments) on the bond (loan) and the
  face value of the bond to be
• Holding other factors constant, the duration of a
  bond will increase with the maturity of the bond,
  and decrease with the coupon rate on the bond.

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Duration of a Firms Assets

• This measure of duration can be extended to any
  asset with expected cash flows on it. Thus, the
  duration of a project or asset can be estimated
  in terms of the pre-debt operating cash flows on
  that project.
• where,
• CFt After-tax operating cash flow on the
  project in year t
• Terminal Value Salvage Value at the end of the
  project lifetime
• N Life of the project
• The duration of any asset provides a measure of
  the interest rate risk embedded in that asset.

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Duration Comparing Approaches
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Operating Income versus Interest Rates

• Change in Operating Income 0.36 2.55 (Change
  in Interest Rates) (11.28) (0.95)
• Generally speaking, the operating cash flows are
  smoothed out more than the value and hence will
  exhibit lower duration that the firm value.

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Sensitivity to Changes in GNP

• The answer to this question is important because
• it provides insight into whether the firms cash
  flows are cyclical and
• whether the cash flows on the firms debt should
  be designed to protect against cyclical factors.
• If the cash flows and firm value are sensitive to
  movements in the economy, the firm will either
  have to issue less debt overall, or add special
  features to the debt to tie cash flows on the
  debt to the firms cash flows.

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Regression Results

• Regressing changes in firm value against changes
  in the GNP over this period yields the following
  regression
• Change in Firm Value 0.74 -7.82 ( GDP Growth)
• (2.05) (0.65)
• Conclusion The Home Depot is counter-cyclical
  (?)
• Regressing changes in operating cash flow against
  changes in GNP over this period yields the
  following regression
• Change in Operating Income 0.41 2.25 ( GNP
  Growth)
• (6.86) (1.14)
• Conclusion The Home Depots operating income is
  slightly less sensitive to the economic cycle,
  but also counter-cyclical.

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Sensitivity to Currency Changes

• The answer to this question is important, because
• it provides a measure of how sensitive cash flows
  and firm value are to changes in the currency
• it provides guidance on whether the firm should
  issue debt in another currency that it may be
  exposed to.
• If cash flows and firm value are sensitive to
  changes in the dollar, the firm should
• figure out which currency its cash flows are in
• and issued some debt in that currency

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Regression Results

• Regressing changes in firm value against changes
  in the dollar over this period yields the
  following regression
• Change in Firm Value 0.52 1.13 ( Change in
  Dollar)
• (2.86) (0.34)
• Conclusion The Home Depots value has not been
  very sensitive to changes in the dollar over the
  last 15 years.
• Regressing changes in operating cash flow against
  changes in the dollar over this period yields the
  following regression
• Change in Operating Income 0.35 - 0.14 ( Change
  in Dollar)
• (10.83) (0.24)
• Conclusion The Home Depots operating income
  has also been unaffected by changes in exchange
  rates.

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Sensitivity to Inflation

• The answer to this question is important, because
• it provides a measure of whether cash flows are
  positively or negatively impacted by inflation.
• it then helps in the design of debt whether the
  debt should be fixed or floating rate debt.
• If cash flows move with inflation, increasing
  (decreasing) as inflation increases (decreases),
  the debt should have a larger floating rate
  component.

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Regression Results

• Regressing changes in firm value against changes
  in inflation over this period yields the
  following regression
• Change in Firm Value 0.45 - 23.39 (Change in
  Inflation Rate)
• (2.78) (1.68)
• Conclusion The Home Depots firm value is
  negatively affected by increases in inflation.
• Regressing changes in operating cash flow against
  changes in inflation over this period yields the
  following regression
• Change in Operating Income 1.40 1.40 (
  Change in Inflation Rate)
• (10.37) (0.50)
• Conclusion The Home Depots operating income is
  also negatively affected by increases in
  inflation, though the effect is smaller.

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Overall Recommendations

• The debt issued should be long term and should
  have a duration of approximately 7.48 years.
• The debt should be fixed-rate debt.
• The debt should be in dollars, if the Home
  Depots future expansion plans involve
  investments in other countries, the firm should
  issue foreign currency debt to finance these
  investments.

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Bottom-up Estimates

• Change in Firm Value versus
• Interest Rates GDP Growth Inflation Currency
• Building Supplies -6.56 0.73 -5.11 -1.93
• On a bottom-up basis,
• The Home Depot should have debt
• With a duration of 6.56 years
• That is unaffected by economic cycles
• Is is fixed rate (Value does not increase as
  inflation goes up)
• In dollars

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Analyzing The Home Depots Current Debt

• The Home Depots existing debt is almost entirely
  in the form of long term leases on U.S. stores.
• Consequently, its existing debt is in line with
  what you would expect the Home Depot to have.

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Analyzing Boeings existing debt

• Existing Debt Optimal
• Duration 7.55 9.05
• Floating Rate Component 12 Low
• Foreign Currency Debt 8 47.24
• Convertible Debt 0 0
• Boeing should increase its proportion of foreign
  currency debt and increase the maturity of its
  debt shortly.
• The optimal debt ratios were estimated based upon
  bottom-up estimates for the aerospace and defense
  businesses.