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Capital Expenditures $1,049 $1,133 $1,224 $1,321 $1,427 $1,541
+ Chg in Work. Cap $65 $42 $45 $48 $52 $56
- Depreciation $1,059 $1,144 $1,235 $1,334 $1,441 $1,556
- Net Income $1,267 $1,368 $1,495 $1,633 $1,784 $1,949
+ Dividends $429 $821 $897 $980 $1,070 $1,169
= New Debt ($783) ($517) ($565) ($617) ($675) ($738)

Beta 1.25 1.23 1.21 1.19 1.18 1.16
Cost of Equity 10.00% 9.91% 9.82% 9.74% 9.67% 9.60%

Growth Rate 8.00% 8.00% 8.00% 8.00% 8.00%
Dividend Payout Ratio 33.86% 60.00% 60.00% 60.00% 60.00% 60.00%

In fact, increasing dividend payout alone is unlikely to increase the debt ratio
2. Repurchase stock each year: This affects the debt ratio in much the same way as does
increasing dividends, because it increases debt requirements and reduces equity. For
instance, if Disney bought back 5% of the stock outstanding each year, the debt ratio at
the end of year 5 would be significantly higher as shown in Table 9.7.

Table 9.7: Estimated Debt Ratio with Equity Buyback of 5% a Year
Current Year 1 2 3 4 5
Equity $55,101 $57,142 $59,312 $61,617 $64,065 $66,666
Debt $14,668 $16,801 $19,025 $21,347 $23,774 $26,316
Debt/(Debt+Equity) 21.02% 22.72% 24.29% 25.73% 27.07% 28.30%


Capital Expenditures $1,049 $1,133 $1,224 $1,321 $1,427 $1,541
+ Chg in Work. Cap $65 $42 $45 $48 $52 $56
- Depreciation $1,059 $1,144 $1,235 $1,334 $1,441 $1,556
- Net Income $1,267 $1,368 $1,408 $1,447 $1,486 $1,525
+ Dividends $429 $463 $477 $490 $503 $516
+ Stock Buybacks $3,007 $3,122 $3,243 $3,372 $3,509
= New Debt ($783) $2,133 $2,224 $2,322 $2,427 $2,542

Beta 1.25 1.26 1.28 1.30 1.32 1.33
Cost of Equity 10.00% 10.09% 10.18% 10.26% 10.34% 10.42%

Growth Rate 8.00% 8.00% 8.00% 8.00% 8.00%
Dividend Payout Ratio 33.86% 33.86% 33.86% 33.86% 33.86% 33.86%

In this scenario, Disney will need to borrow money each year to cover its stock buybacks
and the debt ratio increases to 28.30% by the end of year 5.
3. Increase capital expenditures each year: While the first two approaches increase the
debt ratio by shrinking the equity, the third approach increases the scale of the firm. It
does so by increasing the capital expenditures, which incidentally includes acquisitions of
other firms, and financing these expenditures with debt. Disney could increase its debt
ratio fairly significantly by increasing capital expenditures. In Table 9.8, we estimate the
debt ratio for Disney if it doubles its capital expenditures (relative to the estimates in the
earlier tables) and meets its external financing needs with debt.
Table 9.8: Estimated Debt Ratio with 100% higher Capital Expenditures
Current Year 1 2 3 4 5
Equity $55,101 $60,150 $65,622 $71,553 $77,980 $84,945
Debt $14,668 $14,927 $15,224 $15,566 $15,959 $16,408
Debt/(Debt+Equity) 21.02% 19.88% 18.83% 17.87% 16.99% 16.19%

Capital Expenditures $1,049 $2,266 $2,447 $2,643 $2,854 $3,083
+ Chg in Work. Cap $65 $42 $45 $48 $52 $56
- Depreciation $1,059 $1,144 $1,235 $1,334 $1,441 $1,556
- Net Income $1,267 $1,368 $1,469 $1,577 $1,692 $1,814
+ Dividends $429 $463 $510 $562 $618 $681
+ Stock Buybacks $0 $0 $0 $0 $0
= New Debt ($783) $259 $298 $342 $392 $450

Beta 1.25 1.23 1.22 1.21 1.20 1.20


Cost of Equity 10.00% 9.95% 9.89% 9.85% 9.81% 9.77%

Growth Rate 8.00% 8.00% 8.00% 8.00% 8.00%
Dividend Payout Ratio 33.86% 33.86% 33.86% 33.86% 33.86% 33.86%

With the higher capital expenditures and maintaining the existing dividend payout ratio
of 33.86%, the debt ratio is 16.19% by the end of year 5. This is the riskiest strategy of
the three, since it presupposes the existence of enough good investments (or acquisitions)
to cover $ 15 billion in new investments over the next 5 years. It may, however, be the
strategy that seems most attractive to management that intent on building a global
entertainment empire.
All of this analysis was based upon the presumption that Disney would not be the
target of a hostile acquisition. In February 2004, Comcast announced that it would try to
acquire Disney. While the bid was withdrawn three months later and excess debt capacity
was never cited as a reason for it, is does put pressure on the time table that Disney faces
both for raising the debt ratio and improving returns on investments.

9.5. ˜: Cash Balances and Changing Leverage
Companies with excess debt capacity often also have large cash balances. Which
of the following actions by a company with a large cash balance will increase its debt
a. Using the cash to acquire another company
b. Paying a large special dividend
c. Paying off debt
d. Buying back stock

Illustration 9.4: Decreasing Leverage gradually: Time Warner
In 1994, Time Warner had 379.3 million shares outstanding, trading at $ 44 per
share, and $9.934 billion in outstanding debt, left over from the leveraged acquisition of
Time by Warner Communications in 1989. The EBITDA in 1994 was $ 1.146 billion,
and Time Warner had a beta of 1.30. The optimal debt ratio for Time Warner, based upon


this operating income, is only 10%. Table 9.9 examines the effect on leverage of cutting
dividends to zero and using operating cash flows to take on projects and repay debt.
Table 9.9: Estimated Debt Ratios “ Time Warner
Current Year 1 2 3 4 5
Equity $16,689 $19,051 $21,694 $24,651 $27,960 $31,663
Debt $9,934 $9,745 $9,527 $9,276 $8,988 $8,655
Debt/(Debt+Equity) 37.31% 33.84% 30.52% 27.34% 24.33% 21.47%

Capital $300 $330 $363 $399 $439 $483
- Depreciation $437 $481 $529 $582 $640 $704
- Net Income $35 $39 $52 $68 $88 $112
- Dividends $67 $0 $0 $0 $0 $0
= New Debt ($105) ($189) ($218) ($251) ($289) ($332)
Beta 1.30 1.25 1.21 1.17 1.14 1.11
Cost of Equity 14.15% 13.87% 13.63% 13.42% 13.24% 13.08%
Growth Rate 10.00% 10.00% 10.00% 10.00% 10.00%
Payout Ratio 11% 0% 0% 0% 0% 0%
Allowing for a growth rate of 10% in operating income, Time Warner repays $ 189
million of its outstanding debt in the first year. By the end of the fifth year, the growth in
equity and the reduction in debt combine to lower the debt ratio to 21.47%.

This spreadsheet allows you to estimate the effects of changing dividend policy or
capital expenditures on debt ratios over time.


9.6. ˜: Investing in Other Business Lines
In the analysis above, we have argued that firms should invest in projects as long
as the return on equity is greater than the cost of equity. Assume that a firm is considering
acquiring another firm with its debt capacity. In analyzing the return on equity the
acquiring firm can make on this investment, we should compare the return on equity to
a. the cost of equity of the acquiring firm
b. the cost of equity of the acquired firm
c. a blended cost of equity of the acquired and acquiring firm
d. none of the above

In Practice: Security Innovation and Changing Capital Structure
While the changes in leverage discussed so far in this chapter have been
accomplished using traditional securities such as straight debt and equity, firms that have
specific objectives on leverage may find certain products that are designed to meet those
objectives. Consider a few examples:
Hybrid securities such as convertible bonds are combinations of debt and equity

that change over time as the firm changes. To be more precise, if the firm
prospers and its equity value increases, the conversion option in the convertible
bond will become more valuable, thus increasing the equity component of the
convertible bond and decreasing the debt component (as a percent of the value of
the bond). If the firm does badly and its stock price slides, the conversion option
(and the equity component) will become less valuable and the debt ratio of the
firm will increase.
An alternative available to a firm that wants to increase leverage over time is a

forward contract to buy a specified number of shares of equity in the future. These
contracts lock the firms into reducing their equity over time and may carry a more
positive signal to financial markets than would an announcement of plans to
repurchase stock, since firms are not obligated to carry through on these


A firm with high leverage, faced with a resistance from financial markets to

common stock issues, may consider more inventive ways of raising equity, such
as using warrants and contingent value rights. Warrants represent call options on
the firm™s equity whereas contingent value rights are put options on the firm™s
stock. The former have appeal to those who are optimistic about the future of the
company and the latter make sense for risk averse investors who are concerned
about the future.

Choosing the Right Financing Instruments

In Chapter 7, we presented a variety of ways in which firms can raise debt and
equity. Debt can be bank debt or corporate bonds, can vary in maturity from short to
long term, can have fixed or floating rates and can be in different currencies. In the case
of equity there are fewer choices, but firms can still raise equity from common stock,
warrants or contingent value rights. While we suggested broad guidelines that could be
used to determine when firms should consider each type of financing, we did not develop
a way in which a specific firm can pick the right kind of financing.
In this section, we lay out a sequence of steps by which a firm to choose the right
financing instruments. This analysis is useful not only in determining what kind of
securities should be issued to finance new investments, but also in highlighting
limitations in a firm™s existing financing choices. The first step in the analysis is an
examination of the cash flow characteristics of the assets or projects that will be financed;
the objective is to try to match the cash flows on the liability stream as closely as possible
to the cash flows on the asset stream. We then superimpose a series of considerations that
may lead the firm to deviate from or modify these financing choices.
First, we consider the tax savings that may accrue from using different financing
vehicles, and weigh the tax benefits against the costs of deviating from the optimal
choices. Next, we examine the influence that equity research analysts and ratings agency
views have on the choice of financing vehicles; instruments that are looked on favorably
by either or, better still, both groups will clearly be preferred to those that evoke strong
negative responses from one or both groups. We also factor in the difficulty that some
firms might have in conveying information to markets; in the presence of asymmetric


information, firms may have to make financing choices that do not reflect their asset mix.
Finally, we allow for the possibility that firms may want to structure their financing to
reduce agency conflicts between stockholders and bondholders.

I. Matching financing cash flows with asset cash flows
The first and most important characteristic a firm has to consider in choosing the
financing instrument it will use to raise funds is the cash flow patterns of the assets that
are to be financed with this instrument.

Why match Asset Cash Flows to Cash Flows on Liabilities
We will begin with the premise that the cash flows of a firm™s liability stream
should match the cash flows of the assets that they finance. Let us begin by defining firm
value as the present value of the cash flows generated by the assets owned by the firm.
This firm value will vary over time, not only as a function of firm-specific factors such as
project success, but also as a function of broader macro economic variables such as
interest rates, inflation rates, economic cycles and exchange rates. Figure 9.2 represents
the time series of firm value for a hypothetical firm, where all the changes in firm value
are assumed to result from changes in macro economic variables.
Figure 9.2: Firm Value over time with Short Term Debtt

Firm Value

Value of Equity

Time (t)
This firm can choose to finance these assets with any financing mix it wants. The value
of equity at any point in time is the difference between the value of the firm and the value
of outstanding debt. Assume, for instance, that the firm chooses to finance the assets
shown in Figure 20.2 using very short term debt, and that this debt is unaffected by


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