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In chapter 7, we looked at the wide range of choices available to firms to raise
capital. In chapter 8, developed the tools needed to estimate the optimal debt ratio for a
firm. In this chapter, we discuss how firms can use this information to choose the mix of
debt and equity they use to finance investments, and on the financing instruments they
will employ to reach that mix.
We begin by examining whether, having identified an optimal debt ratio, firms
should move to that debt ratio from current levels. A variety of concerns may lead a firm
not to use its excess debt capacity, if it is under levered, or to lower its debt, if it is over
levered. A firm that decides to move from its current debt level to its optimal financing
mix has two decisions to make. First, it has to consider how quickly it wants to move.
The degree of urgency will vary widely across firms, depending upon how much of a
threat they perceive from being under (or over) levered. The second decision is whether
to increase (or decrease) the debt ratio by recapitalizing its investments, by divesting
assets and using the cash to reduce debt or equity, by investing in new projects with debt
or equity, or by changing its dividend policy.
In the second part of this chapter, we consider how firms should choose the right
financing vehicle for raising capital for their investments. We argue that a firm™s 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. We then consider a number of real
world concerns including tax law, the views of ratings agencies, and information effects
that might lead firms to modify their financing choices.

A Framework for Capital Structure Changes

A firm whose actual debt ratio is very different from its optimal has several
choices to make. First, it has to decide whether to move towards the optimal or to
preserve the status quo. Second, once it decides to move towards the optimal, the firm
has to choose between changing its leverage quickly or moving more deliberately. This
decision may also be governed by pressure from external sources, such as impatient


stockholders or bond ratings agency concerns. Third, if the firm decides to move
gradually to the optimal, it has to decide whether to use new financing to take new
projects, or to shift its financing mix on existing projects.
In the last chapter, we presented the rationale for moving towards the optimal in
terms of the value that could be gained for stockholders by doing so. Conversely, the cost
of preserving the status quo is this potential value increment. While managers nominally
make this decision, they will often find themselves under some pressure from
stockholders, if they are under levered, or under threat of bankruptcy, if they are over
levered, to move towards their optimal debt ratios.

Immediate or Gradual Change
In chapter 7 we discussed the trade off between using debt and using equity. In
chapter 8, we developed a number of approaches that we used to determine the optimal
financing mix for a firm. The next logical step, it would seem, is for firms to move to this
optimal mix. In this section, we will first consider what might lead some firms not to
make this move, and we follow up by looking at some of the decisions firms that choose
this move then have to make.

No change, gradual change or immediate change
In the last chapter, we implicitly assumed that firms that have debt ratios different
from their optimal debt ratios, once made aware of this gap, will want to move to the
optimal ratios. That does not always turn out to be the case. There are a number of firms
that look under levered, using any of the approaches described in the last section, but
choose not to use their excess debt capacity. Conversely, there are a number of firms with
too much debt that choose not to pay down debt. At the other extreme, there are firms
that shift their financing mix overnight to reflect the optimal mix. In this section, we look
at the factors a firm might have to consider in deciding whether to leave its debt ratio
unchanged, change gradually or change immediately to the optimal mix.

To change or not to change
Firms that are under of overlevered might choose not to move to their optimal debt
ratios for a number of reasons. Given our identification of the optimal debt ratio as the


mix at which firm value is maximized, this inaction may seem not only irrational but
value destroying for stockholders. In some cases, it is. In some cases, however, not
moving to the optimal may be consistent with value maximization.
Let us consider under levered firms first. The first reason a firm may choose not to
move to its optimal debt ratio, estimated using one of the approaches described in the last
chapter, is that it does not view its objective as maximizing firm value. If the objective of
a firm is to maximize net income or maintain a high bond rating, having less debt is more
desirable than having more. Stockholders should clearly take issue with managers who
avoid borrowing because they have an alternative objective and force them to justify their
use of the objective.
Even when firms agree on firm value maximization as the objective, there are a
number of reasons why under levered firms may choose not to use their excess debt
When firms borrow, the debt usually comes with covenants that restrict what the firm

can do in the future. Firms that value flexibility may choose not to use their perceived
debt capacity.
The flexibility argument can also be extended to cover future financing needs. Firms

that are uncertain about future financing needs may want to preserve excess debt
capacity to cover these needs.
In closely held or private firms, the likelihood of bankruptcy that comes with debt

may be weighted disproportionately1 in making the decision to borrow.
These are all viable reasons for not using excess debt capacity, and they may be
consistent with value maximization. We should, however, put these reasons to the
financial test. For instance, we estimated in illustration 7.3 that the value of Disney, as a
firm, will increase almost $ 3 billion if it moves to its optimal debt ratio. If the reason
given by the firm™s management for not using excess debt capacity is the need for
financing flexibility, the value of this flexibility has to be greater than $ 3 billion.

1 We do consider the likelihood of default in all the approaches described in the last chapter. However, this
consideration does not allow for the fact that cost of default may vary widely across firms. The manager of
a publicly traded firm may lose only his or her job, in the event of default, whereas the owner of a private
business may lose both wealth and reputation, if he or she goes bankrupt.


Firms that have too much debt, relative to their optimal, should have a fairly
strong incentive to try to reduce it. Here, again, there might be reasons why a firm may
choose not to take this path. The primary fear of over levered firms is bankruptcy. If the
government makes a practice of shielding firms from the costs associated with default, by
either bailing out firms that default on their debt or backing up the loans made to them by
banks, firms may choose to remain over levered. This would explain why Korean firms,
that looked over levered using any financial yardstick in the 1990s did nothing to reduce
their debt ratios, until the government guarantee collapsed.

In Practice: Valuing Financial Flexibility as an option
If we assume that unlimited and costless access to capital markets, a firm will
always be able to fund a good projects by raising new capital. If, on the other hand, we
assume that there are internal or external constraints on raising new capital, financial
flexibility can be valuable. To value financial flexibility as an option, assume that a firm
has expectations about how much it will need to reinvest in future periods, based upon its
own past history and current conditions in the industry. Assume also that a firm has
expectations about how much it can raise from internal funds and its normal access to
capital markets in future periods. There is uncertainty about future reinvestment needs;
for simplicity, we will assume that the capacity to generate funds is known with certainty
to the firm. The advantage (and value) of having excess debt capacity or large cash
balances is that the firm can meet any reinvestment needs, in excess of funds available,
using its debt capacity. The payoff from these projects, however, comes from the excess
returns the firm expects to make on them.
With this framework, we can specify the types of firms that will value financial
flexibility the most.
a. Access to capital markets: Firms with limited access to capital markets “ private
business, emerging market companies and small market cap companies “ should
value financial flexibility more that firms with wider access to capital.
b. Project quality: The value of financial flexibility accrues not just from the fact that
excess debt capacity can be used to fund projects but from the excess returns that
these projects earn. Firms in mature and competitive businesses, where excess returns


are close to zero, should value financial flexibility less than firms with substantial
competitive advantages and high excess returns.
c. Uncertainty about future investment needs: Firms that can forecast their reinvestment
needs with certainty do not need to maintain excess debt capacity since they can plan
to raise capital well in advance. Firms in volatile businesses where investment needs
can shift dramatically from period to period will value financial flexibility more.
The bottom line is that firms that value financial flexibility more should be given more
leeway to operate with debt ratios below their theoretical optimal debt ratios (where the
cost of capital is minimized).

Gradual versus Immediate Change
Many firms attempt to move to their optimal debt ratios, either gradually over
time or immediately. The advantage of an immediate shift to the optimal debt ratio is that
the firm immediately receives the benefits of the optimal leverage, which include a lower
cost of capital and a higher value. The disadvantage of a sudden change in leverage is
that it changes both the way managers make decisions and the environment in which
these decisions are made. If the optimal debt ratio has been incorrectly estimated, a
sudden change may also increase the risk that the firm has to backtrack and reverse its
financing decisions. To illustrate, assume that a firm™s optimal debt ratio has been
calculated to be 40% and that the firm moves to this optimal from its current debt ratio of
10%. A few months later, the firm discovers that its optimal debt ratio is really 30%. It
will then have to repay some of the debt it has taken on in order to get back to the optimal

Gradual versus Immediate Change for Under Levered firms
For underlevered firms, the decision to increase the debt ratio to the optimal either
quickly or gradually is determined by four factors:
1. Degree of Confidence in the Optimal Leverage Estimate: The greater the possible error
in the estimate of optimal leverage, the more likely the firm will choose to move
gradually to the optimal.
2. Comparability to Industry: When the optimal debt ratio for a firm differs markedly
from that of the industry to which the firm belongs, the firm is much less likely to shift to


the optimal quickly, because analysts and ratings agencies might not look favorably on
the change.
3. Likelihood of a Takeover: Empirical studies of the characteristics of target firms in
acquisitions have noted that underlevered firms are much more likely to be acquired than
are overlevered firms2. Often, the acquisition is financed at least partially by the target
firm™s unused debt capacity. Consequently, firms with excess debt capacity that delay
increasing debt run the risk of being taken over. The greater this risk, the more likely the
firm will choose to take on additional debt quickly. Several additional factors may
determine the likelihood of a takeover. One is the prevalence of anti-takeover laws (at the
state level) and amendments in the corporate charter designed specifically to prevent
hostile acquisitions. Another is the size of the firm. Since raising financing for an
acquisition is far more difficult for a $ 100 billion firm than for a $ 1 billion firm, larger
firms may feel more protected from the threat of hostile takeovers. The third factor is the
extent of holdings by insiders and managers in the company. Insiders and managers with
substantial stakes may be able to prevent hostile acquisitions.
4. Need for Financial Flexibility: On occasions, firms may require excess debt capacity
to meet unanticipated needs for funds, either to maintain existing projects, or to invest in
new ones. Firms that need and value this flexibility will be less likely to shift quickly to
their optimal debt ratios and use up their excess debt capacity.

9.1. ˜: Insider Holdings and Leverage
Closely held firms (where managers and insiders hold a substantial portion of the
outstanding stock) are less likely to increase leverage quickly than firms with widely
dispersed stockholdings.
a. True
b. False

2 Palepu (1986) notes that one of the variables that seems to predict a takeover is a low debt ratio, in
conjunction with poor operating performance.


Illustration 9.1: Debt Capacity and Takeovers
The Disney acquisition of Capital Cities in 1996, although a friendly acquisition,
illustrates some of advantages to the acquiring firm of acquiring an under levered firm.
At the time of the acquisition, Capital Cities had $ 657 million in outstanding debt and
154.06 million shares outstanding, trading at $ 100 per share. Its market value debt ratio
was only 4.07%. With a beta of 0.95, a borrowing rate of 7.70%, and a corporate tax rate
of 43.50%, this yielded a cost of capital of 11.90%. (The treasury bond rate at the time of
the analysis was 7%)
Cost of Capital
= Cost of Equity(Equity/(Debt+ Equity)+Cost of Debt(Debt/(Debt + Equity)
= 12.23% (15,406/(15,406+657)) + 7.70% (1-.435) (657/(15,406+657))
= 11.90%
Table 9.1 summarizes the costs of equity, debt, and capital, as well as the estimated firm
values and stock prices at different debt ratios for Capital Cities:
Table 9.1: Costs of Financing, Firm Value and Debt Ratios: Capital Cities
Debt Beta Cost of Interest Bond Interest Cost of Cost of Firm Stock
Ratio Equity Coverage Rating Rate Debt Capital Value Price
0.00% 0.93 12.10% ∞ AAA 7.30% 4.12% 12.10% $15,507 $96.41
10.00% 0.99 12.42% 10.73 AAA 7.30% 4.12% 11.59% $17,007 $106.15
20.00% 1.06 12.82% 4.75 A 8.25% 4.66% 11.19% $18,399 $115.19
30.00% 1.15 13.34% 2.90 BBB 9.00% 5.09% 10.86% $19,708 $123.69
40.00% 1.28 14.02% 1.78 B 11.00% 6.22% 10.90% $19,546 $122.63
50.00% 1.45 14.99% 1.21 CCC 13.00% 7.35% 11.17% $18,496 $115.81
60.00% 1.71 16.43% 1.00 CCC 13.00% 7.35% 10.98% $19,228 $120.57
70.00% 2.37 20.01% 0.77 CC 14.50% 9.63% 12.74% $13,939 $86.23
80.00% 3.65 27.08% 0.61 C 16.00% 11.74% 14.81% $10,449 $63.58
90.00% 7.30 47.16% 0.54 C 16.00% 12.21% 15.71% $9,391 $56.71

Note that the firm value is maximized at a debt ratio of 30%, leading to an increase in the
stock price of $ 23.69 over the market price of $ 100.
Although debt capacity was never stated as a reason for Disney™s acquisition of
Capital Cities, Disney borrowed about $ 10 billion for this acquisition and paid $ 125 per

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