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share. Capital Cities™ stockholders could well have achieved the same premium, if


management had borrowed the money and repurchased stock. Although Capital Cities
stockholders did not lose as a result of the acquisition, they would have (at least based on
our numbers) if Disney had paid a smaller premium on the acquisition.

Gradual versus Immediate Change for Overlevered firms
Firms that are over levered also have to decide whether they should shift
gradually or immediately to the optimal debt ratios. As in the case of underlevered firms,
the precision of the estimate of the optimal leverage will play a role, with more precise
estimates leading to quicker adjustments. So will comparability to other firms in the
sector. When most or all of the firms in a sector become over levered, as was the case
with the telecommunications sector in the late 1990s, firms seem to feel little urgency to
reduce their debt ratios even though they might be straining to make their payments. In
contrast, the pressure to reduce debt is much greater when a firm has a high debt ratio in a
sector where most firms have lower debt ratios.
The other factor, in the case of over levered firms, is the possibility of default.
Too much debt also results in higher interest rates and lower ratings on the debt. Thus,
the greater the chance of bankruptcy, the more likely the firm is to move quickly to
reduce debt and move to its optimal. How can we assess the probability of default? If
firms are rated, their bond ratings offer a noisy but simple measure of default risk. A firm
with a below investment grade rating (below BBB) has a significant probability of
default. Even if firms are not rated, we can use their synthetic ratings (based upon interest
coverage ratios) to come to the same conclusion.

9.2. ˜: Indirect Bankruptcy Costs and Leverage
In chapter 7, we talked about indirect bankruptcy costs, where the perception of
default risk affected sales and profits. Assume that a firm with substantial indirect
bankruptcy costs has too much debt. Is the urgency to get back to an optimal debt ratio
for this firm greater than or lesser than it is for a firm without such costs?
a. Greater
b. Lesser


Implementing Changes in Financial Mix
A firm that decides to change its financing mix has several alternatives. In this
section, we begin by considering the details of each of these alternatives to changing the
financing mix, and we conclude by looking at how firms can choose the right approach
for them.

Ways of changing the financing mix
There are four basic paths available to a firm that wants to change its financing
mix. One is to change the current financing mix, using new equity to retire debt or new
debt to reduce equity; this is called recapitalization. The second path is to sell assets and
use the proceeds to pay off debt, if the objective is to reduce the debt ratio, or to reduce
equity, if the objective is to increase the debt ratio. The third is to use a disproportionately
high debt or equity ratio, relative to the firm™s current ratios, to finance new investments
over time. The value of the firm increases, but the debt ratio will also be changed in the
process. The fourth option is to change the proportion of earnings that a firm returns to its
stockholders in the form of dividends or by buying back stock. As this proportion
changes, the debt ratio will also change over time.

The simplest and often the quickest way to change a firm™s financial mix is to
change the way existing investments are financed. Thus, an underlevered firm can
increase its debt ratio by borrowing money and buying back stock or replacing equity
with debt of equal market value.
Borrowing money and buying back stock (or
• Debt-for-Equity Swaps: This is a
voluntary exchange of outstanding
paying a large dividend) increases the debt ratio
equity for debt of equal market
because the borrowing increases the debt, while the
equity repurchase or dividend payment
concurrently reduces the equity. Many companies have used this approach to increase
leverage quickly, largely in response to takeover attempts. For example, in 1985, to


stave off a hostile takeover3, Atlantic Richfield borrowed $ 4 billion and repurchased
stock to increase its debt to capital ratio from 12% to 34%.
In a debt-for-equity swap, a firm replaces equity with debt of equivalent market value

by swapping the two securities. Here again, the simultaneous increase in debt and the
decrease in equity causes the debt ratio to increase substantially. In many cases, firms
offer equity investors a combination of cash and debt in lieu of equity. In 1986, for
example, Owens Corning gave its stockholders $ 52 in cash and debt, with a face
value of $ 35, for each outstanding share, thereby increasing its debt and reducing
In each of these cases, the firm may be restricted by bond covenants that explicitly
prohibit these actions or impose large penalties on the firm. The firm will have to weigh
these restrictions against the benefits of the higher leverage and the increased value that
flows from it. A recapitalization designed to increase the debt ratio substantially is called
a leveraged recapitalization, and many of these recapitalizations are motivated by a
desire to prevent a hostile takeover4.
Though it is far less common, firms that want to lower their debt ratios can adopt
a similar strategy. An overlevered firm can attempt to renegotiate debt agreements, and
try to convince some of the lenders to take an equity stake in the firm in lieu of some or
all of their debt in the firm. It can also try to get lenders to offer more generous terms,
including longer maturities and lower interest rates. Finally, the firm can issue new equity
and use it pay off some of the outstanding debt. The best bargaining chip such a firm
possesses is the possibility of default, since default creates substantial losses for lenders.
In the late 1980s, for example, many U.S. banks were forced to trade in their Latin
American debt for equity stakes or receive little or nothing on their loans.

Divestiture and Use of Proceeds
Firms can also change their debt ratios by selling assets and using the cash they
receive from the divestiture to reduce debt or equity. Thus, an underlevered firm can sell
some of its assets and use the proceeds to repurchase stock or pay a large dividend. While

3 The stock buyback increased the stock price and took away a significant rationale for the acquisition.


this action reduces the equity outstanding at the firm, it will increase the debt ratio of the
firm only if the firm already has some debt outstanding. An overlevered firm may choose
to sell assets and use the proceeds to retire some of the outstanding debt and reduce its
debt ratio.
If a firm chooses this path, the choice of which assets to divest is a critical one.
Firms usually want to divest themselves of investments that are earning less than their
required returns, but that cannot be the overriding consideration in this decision. The key
question is whether there are potential buyers for the asset who are willing to pay fair
value or more for it, where the fair value measures how much the asset is worth to the
firm, based upon its expected cash flows.

9.3. ˜: Asset Sales to Reduce Leverage
Assume that a firm has decided to sell assets to pay off its debt. In deciding which
assets to sell, the firm should
a. Sell its worst performing assets to raise the cash
b. Sell its best performing assets to raise the cash
c. Sell its most liquid assets to raise the cash
d. None of the above (Specify the alternative)

Financing New Investments
Firms can also change their debt ratios by financing new investments
disproportionately with debt or equity. If they use a much higher proportion of debt in
financing new investments than their current debt ratio, they will increase their debt
ratios. Conversely, if they use a much higher proportion of equity in financing new
investments than their existing equity ratio, they will decrease their debt ratios.
There are two key differences between this approach and the previous two. First,
since new investments are spread out over time, the debt ratio will adjust gradually over
the period. Second, the process of investing in new assets will increase both the firm

4 An examination of 28 re-capitalizations between 1985 and 1988 indicates that all but 5 were motivated by
the threat of hostile takeovers.


value and the dollar debt that goes with any debt ratio. For instance, if Disney decides to
increase its debt ratio to 30% and proposes to do so by investing in new stores, the value
of the firm will increase from the existing level.

Changing Dividend Payout
While we will not be considering dividend policy in detail until the next chapter, a
firm can change its debt ratio over time by changing the proportion of its earnings that it
returns to stockholders in each period. Increasing the proportion of earnings paid out in
dividends (the dividend payout ratio) or buying back stock each period will increase the
debt ratio for two reasons. First, the payment of the dividend or buying back stock will
reduce5 the equity in the firm; holding debt constant, this will increase the debt ratio.
Second, paying out more of the earnings to stockholders increases the need for external
financing to fund new investments; if firms fill this need with new debt, the debt ratio
will be increased even further. Decreasing the proportion of earnings returned to
stockholders will have the opposite effects.
Firms that choose this route have to recognize that debt ratios will increase
gradually over time. In fact, the value of equity in a firm can be expected to increase each
period by the expected price appreciation rate. This rate can be obtained from the cost of
equity, after netting out the expected portion of the return that will come from dividends.
This portion is estimated with the dividend yield, which measures the expected dollar
dividend as a percent of the current stock price:
Expected price appreciation = Cost of equity “ Expected dividend yield
To illustrate, in 2004, Disney had a cost of equity of 10.00% and an expected dollar
dividend per share of $0.21. Based upon the stock price of $ 26.91, the expected price
appreciation can be computed:
Expected price appreciationDisney = 10.00% - ($0.21/26.91) = 9.22%
Disney™s market value of equity can be expected to increase 9.22% next period. The
dollar debt would have to increase by more than that amount for the debt ratio to

5 The payment of dividends takes cash out of the firm and puts it in the hands of stockholders. The firm has
to become less valuable, as a result of the action. The stock price reflects this effect.


9.4. ˜: Dollar Debt versus Debt Ratio
Assume that a firm, worth $ 1 billion, has no debt and needs to get to a 20% debt ratio.
How much would the firm need to borrow if it wants to buy back stock?
a. $ 200 million
b. $ 250 million
c. $ 260 million
d. $ 160 million
How much would it need to borrow if it were planning to borrow money and invest in
new projects (with zero net present value)? What if the projects had a net present value
of $ 50 million?

Choosing between the alternatives
Given the choice between recapitalizating, divestitng, financing new investments
and changing dividend payout, how can a firm choose the right way to change debt
ratios? The choice will be determined by three factors. The first is the 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, on the other hand, is a long term strategy to
change debt ratios. Thus, a firm that needs to change its debt ratio quickly, because it is
either under threat of a hostile takeover or faces imminent default, is more likely to use
recapitalizations than to finance new investments.
The second factor is the quality of new investments. In the earlier chapters on
investment analysis, we defined a good investment as one that earns a positive net present
value and a return greater than its hurdle rate. Firms with good investments will gain
more by financing these new investments with new debt if the firm is under levered, or
with new equity if the firm is over levered. Not only will the firm value increase by the
value gain we computed in chapter 8, based upon the change in the cost of capital, but the
positive net present value of the project will also accrue to the firm. On the other hand,
using excess debt capacity or new equity to invest in poor projects is a bad strategy, since
the projects will destroy value.


The final consideration is the marketability of existing investments. Two
considerations go into marketability. One is whether existing investments earn excess
returns; firms are often more willing to divest themselves of assets that are earning less
than the required return. The other, and in our view the more important consideration is
whether divesting these assets will generate a price high enough to compensate the firm
for the cash flows lost by selling them. Ironically, firms often find that their best
investments are more likely to meet the second criterion than their worst investments.
We summarize our conclusions about the right route to follow to the optimal,
based upon all these determinants, in table 9.2:
Table 9.2: Optimal Route to Financing Mix
Desired Speed Marketability of Quality of Optimal Route to changing debt
of Adjustment existing investments new ratio
Urgent Poor Poor Recapitalize
Urgent Good Good Divest & buy back stock or
retire debt
Finance new investments with
Urgent Good Poor Divest & buy back stock or
retire debt
Gradual Neutral or Poor Neutral or Increase payout to stockholders
poor or retire debt over time.
Gradual Good Neutral or Divest and increase payout to
poor stockholders or retire debt over
Gradual Neutral or Poor Good Finance new investments with
debt or equity.
We also summarize our discussion of whether a firm should shift to its financing mix
quickly or gradually, as well as the question of how to make this shift, in figure 9.1.


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