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across companies within a sector. Then, we would expect debt ratios to be different
across firms. The second occurs when firms, on average, have too much or too little debt,
given their characteristics. This can happen when an entire sector changes. For instance,
phone companies have historically had stable and large earnings, because they have had
monopoly power. As technology and new competition breaks down this power, it is
entirely possible that earnings will become more volatile and that these firms should
carry a lot less debt than they do currently.


Following A Financing Hierarchy

There is evidence that firms follow a financing hierarchy: retained earnings are
the most preferred choice for financing, followed by debt, new equity, common and
preferred; convertible preferred is the least preferred choice. For instance, in the survey
by Pinegar and Wilbricht (Table 7.10), managers were asked to rank six different sources
of financing - internal equity, external equity, external debt, preferred stock, and hybrids
(convertible debt and preferred stock)- from most preferred to least preferred.
Table 7.10: Survey Results on Planning Principles
Ranking Source Planning Principle cited
1 Retained Earnings None
2 Straight Debt Maximize security prices
3 Convertible Debt Cash Flow & Survivability
4 Common Stock Avoiding Dilution
5 Straight Preferred Stock Comparability
6 Convertible Preferred None
One reason for this hierarchy is that managers value flexibility and control. To the extent
that external financing reduces flexibility for future financing (especially if it is debt) and
control (bonds have covenants; new equity attracts new stockholders into the company
and may reduce insider holdings as a percentage of total holding), managers prefer
retained earnings as a source of capital. Another reason is it costs nothing in terms of
issuance costs to use retained earnings, it costs more to use external debt and even more
to use external equity.
The survey yielded some other interesting conclusions as well. External debt is
strongly preferred over external equity as a way of raising funds. The values of external
debt and external equity issued between 1975 and 1998 by U.S. corporations are shown
in Figure 7.11 and bear out this preference.


Figure 15.6: External Equity vs External Debt











1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998

External Financing from Common and Preferred Stock External Financing from Debt

Source: Compustat
Given a choice, firms would much rather use straight debt than convertible debt, even
though the interest rate on convertible debt is much lower. Managers perhaps have a
much better sense of the value of the conversion option than is recognized.
A firm™s choices may say a great deal about its financial strength. Thus, the 1993
decisions by RJR Nabisco and GM to raise new funds through convertible preferred
stock were seen by markets as an admission by these firms of their financial
weakness. Not surprisingly, the financial market response to the issue of securities
listed in Table 7.10 mirrors the preferences: the most negative responses are reserved
for securities near the bottom of the list, the most positive (or at least the least
negative) for those at the top of the list.
Why do firms have a financing hierarchy? In the discussion of financing choices so
far, we have steered away from questions about how firms convey information to
financial markets with their financing choices and how well the securities that the firms
issue are priced. Firms know more about their future prospects than do the financial
markets that they deal with; markets may under or overprice securities issued by firms.
Myers and Majluf (1984) note that, in the presence of this asymmetric information, firms


that believe their securities are under priced, given their future prospects, may be inclined
to reject good projects rather than raise external financing. Alternatively, firms that
believe their securities are overpriced are more likely to issue these securities, even if
they have no projects available. In this environment, the following implications emerge “
Managers prefer retained earnings to external financing, since it allows them to

consider projects on their merits, rather than depending upon whether markets are
pricing their securities correctly. It follows then that firms will be more inclined to
retain earnings over and above their current investment requirements to finance future
When firms issue securities, markets will consider the issue a signal that these

securities are overvalued. This signal is likely to be more negative for securities, such
as stocks, where the asymmetry of information is greater, and smaller for securities,
such as straight bonds, where the asymmetry is smaller. This would explain both the
rankings in the financial hierarchy and the market reaction to these security issues.

7.17. ˜: Value of Flexibility and Firm Characteristics
You are reading the Wall Street Journal and notice a tombstone ad for a company,
offering to sell convertible preferred stock. What would you hypothesize about the health
of the company issuing these securities?
a. Nothing
b. Healthier than the average firm
c. In much more financial trouble than the average firm

In this chapter, we have laid the ground work for analyzing a firm™s optimal mix
of debt and equity by laying out the benefits and the costs of borrowing money. In
particular, we made the following points:
We differentiated between debt and equity, at a generic level, by pointing out that any

financing approach that results in fixed cash flows and has prior claims in the case of
default, fixed maturity, and no voting rights is debt, while a financing approach that


provides for residual cash flows and has low or no priority in claims in the case of
default, infinite life, and a lion™s share of the control is equity.
While all firms, private as well as public, use both debt and equity, the choices in

terms of financing and the type of financing used change as a firm progresses through
the life cycle, with equity dominating at the earlier stages and debt as the firm
The primary benefit of debt is a tax benefit: interest expenses are tax deductible and

cash flows to equity (dividends) are not. This benefit increases with the tax rate of the
entity taking on the debt. A secondary benefit of debt is that it forces managers to be
more disciplined in their choice of projects by increasing the costs of failure; a series
of bad projects may create the possibility of defaulting on interest and principal
The primary cost of borrowing is an increase in the expected bankruptcy cost ““ the

product of the probability of default and the cost of bankruptcy. The probability of
default is greater for firms that have volatile cash flows. The cost of bankruptcy
includes both the direct costs (legal and time value) of bankruptcy and the indirect
costs (lost sales, tighter credit and less access to capital). Borrowing money exposes
the firm to the possibility of conflicts between stock and bond holders over
investment, financing, and dividend decisions. The covenants that bondholders write
into bond agreements to protect themselves against expropriation cost the firm in both
monitoring costs and lost flexibility. The loss of financial flexibility that arises from
borrowing money is more likely to be a problem for firms with substantial and
unpredictable investment opportunities.
In the special case where there are no tax benefits, default risk, or agency problems,

the financing decision is irrelevant. This is known as the Miller-Modigliani theorem.
In most cases, however, the trade-off between the benefits and costs of debt will
result in an optimal capital structure, whereby the value of the firm is maximized.
Firms generally choose their financing mix in one of three ways “ based upon where

they are in the life cycle, by looking at comparable firms or by following a financing
hierarchy where retained earnings is the most preferred option and convertible
preferred stock the least.


Live Case Study
Analyzing A Firm™s Current Financing Choices
Objective: To examine a firm™s current financing choices and to categorize them into
debt (borrowings) and equity and to examine the trade off between debt and equity for
your firm.

Key Questions:
Where and how does the firm get its current financing?

Would these financing choices be classified as debt, equity or as hybrid

How large, in qualitative or quantitative terms, are the advantages to this company

from using debt?
How large, in qualitative or quantitative terms, are the disadvantages to this

company from using debt?
From the qualitative trade off, does this firm look like it has too much or too little


Framework for Analysis:
Assessing Current Financing

1.1. How does the firm raise equity?
If it is a publicly traded firm, it can raise equity from common stock and warrants
or options
If is a private firm, the equity can come from personal savings and venture capital.
1.2. How (if at all) does the firm borrow money?
If it is a publicly traded firm, it can raise debt from bank debt or corporate bonds
1.3. Does the firm use any hybrid approaches to raising financing, that combine some
of the features of debt and some of equity?
Examples would include preferred stock, convertible bonds and bonds with
warrants attached to them
2. Detailed Description of Current Financing
2.1. If the firm raises equity from warrants or convertibles, what are the
characteristics of the options? (Exercise price, maturity etc.)


2.2. If the firm has borrowed money, what are the characteristics of the debt?
(Maturity, Coupon or Stated interest rate, call features, fixed of floating rate, secured
or unsecured and currency)
2.3. If the firm has hybrid securities, what are the features of the hybrid securities?
3. Break Down into Debt and Equity
3.1. If the firm has financing with debt and equity components (such as
convertible bonds), how much of the value can be attributed to debt and how
much to equity?
3.2. Given the coupon or stated interest rate and maturity of the non-traded debt,
what is the current estimated market value of the debt?
3.3 What is the market value of equity that the firm has outstanding?
4. Trade off on Debt versus Equity
Benefits of Debt
What marginal tax rate does this firm face and how does this measure up to

the marginal tax rates of other firms? Are there other tax deductions that this
company has (like depreciation) to reduce the tax bite?
Does this company have high free cash flows (for eg. EBITDA/Firm Value)?

Has it taken and does it continue to have good investment projects? How
responsive are managers to stockholders? (Will there be an advantage to using
debt in this firm as a way of keeping managers in line or do other (cheaper)
mechanisms exist?)
Costs of Debt


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