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want to consider using either Mexican Peso or Brazilian Real debt as well.
These conclusions can be used to both design the new debt issues that the firm will be
making going forward, and to evaluate the existing debt on the firm™s books to see if
there is a mismatching of assets and financing in the current firm. Examining Disney™s
debt at the end of 2003, we note the following.
Disney has $13.1 billion in debt with an average maturity of 11.53 years. Even

allowing for the fact that the maturity of debt is higher than the duration, this
would indicate that Disney™s debt is far too long term for its existing business
Of the debt, about 12% is Euro debt and no yen denominated debt. Based upon

our analysis, a larger portion of Disney™s debt should be in foreign currencies.
Disney has about $1.3 billion in convertible debt and some floating rate debt,

though no information is provided on its magnitude. If floating rate debt is a
relatively small portion of existing debt, our analysis would indicate that Disney
should be using more of it.
If Disney accepts the recommendation that its debt should be more short term, more
foreign currency and more floating rate debt, it can get there in two ways:


It can swap some of its existing long term, fixed rate, dollar debt with shorter

term, floating rate, foreign currency debt. Given Disney™s standing in financial
markets and its large market capitalization, this should not be difficult to do.
If Disney is planning new debt issues, either to get to a higher debt ratio or to fund

new investments, it can use primarily short term, floating rate, foreign currency
debt to fund these new investments. While it may be mismatching the funding on
these investments, its debt matching will become better at the company level.

macrodur.xls: This spreadsheet allows you to estimate the sensitivity of firm value
and operating income to changes in macro-economic variables.

dursect.xls: There is a dataset on the web that summarizes the results of
regressing firm value against macroeconomic variables, by sector, for U.S. companies.

Illustration 9.7: Estimating the Right Financing Mix for Bookscape, Aracruz and
Deutsche Bank
While we will not examine the right financing type for Bookscape, Aracruz and
Deutsche Bank in the same level of detail as we did for Disney, we will summarize,
based upon our understanding of their businesses, what we think will be the best kind of
financing for each of these firms:
Bookscape: Given Bookscape™s dependence upon revenues at its New York

bookstores, we would design the debt to be
Long term, since the store is a long term investment

Dollar-denominated, since all the cash flows are in dollars

Fixed rate debt, since Bookscapes lack of pricing power makes it unlikely that

they can keep pace with inflation
It is worth noting that operating leases fulfill all of these conditions, making it the
apprpriate debt for Bookscape. Since that is the only debt that Bookscape carries
currently, we would suggest no changes.
Aracruz: Aracruz operates most of its paper plants in Brazil, but gets a significant

proportion of its products overseas. More than 80% of its revenues in 2003 were to


other countries, and the bulk of these revenues were dollar-denominated. Given this
structure, we would design debt to be
Long term, since a typical paper plant has a life in excess of 20 years,

Dollar-denominated, since the cash inflows are primarily in dollars,

Given the volatility of paper prices, we would try to link the interest rate on

debt to pulp prices, if possible.
The existing debt at Aracruz is primarily dollar debt but it is short term, with an
average maturity of 3.20 years. While this may reflect the difficulties that Brazilian
firms have faced in borrowing long term historically, the constraints on borrowing
long term are easing for many emerging market companies that derive the bulk of
their revenues in dollars.
Deutsche Bank: In the case of Deutsche Bank, the recommendation is made simpler

by the fact that the debt ratio we are analyzing is the long-term debt ratio. In addition
to being long term, however, the debt should reflect
The mix of currencies in which Deutsche Bank gets its cash flows, which

should lead to significant dollar (from its U.S. holdings) and British Pound
(from its Morgan Grenfell subsidiary) debt issues. In future years, this would
expand to include more emerging market debt issues to reflect Deutsche
Bank™s greater dependence on cash flows from these markets.
The changing mix of Deutsche Bank™s business to reflect its increasing role in

investment banking.
It is possible that Deutsche Bank™s reputation in Europe may allow it to borrow
more cheaply in some markets (say, Germany) than in others. If that is the case, it
can either issue its dollar-denominated or pound-denominated debt in those
markets, or issued debt in Euros and then swap the debt into U.S. dollar or British
pound debt.


In this chapter, we examine how firms change debt ratios towards the optimal,
and how they choose the right financing vehicles to use, to both finance existing assets
and new investments.


Some firms that are under or over levered may choose to not change their debt
ratios to the optimal. This may arise either because they do not share the objective of
maximizing firm value that underlies optimal debt ratios, or because they feel that the
costs of moving to the optimal outweigh the benefits. Firms that do decide to change their
financing mixes can change either gradually or quickly. Firms are much more likely to
change their financing mixes quickly if external pressure is brought to bear on the firm.
For under levered firms, the pressure takes the form of hostile acquisitions, whereas for
over levered firms, the threat is default and bankruptcy. Firms that are not under external
pressure for change have the luxury of changing towards their optimal debt ratios
Firms can change their debt ratios in four ways. They can recapitalize existing
investments, using new debt to reduce equity or new equity to retire debt. They can divest
existing assets, and use the cash to reduce equity or retire debt. They can invest in new
projects, and finance these investments disproportionately with debt or equity. Finally,
they can increase or decrease the proportion of their earnings that are returned to
stockholders, in the form of dividends or stock buybacks. To decide between these
alternatives, firms have to consider how quickly they need to change their debt ratios, the
quality of the new investments they have and the marketability of existing investments.
In the final section, we examine how firms choose between financing vehicles.
Matching cash flows on financing to the cash flows on assets reduces default risk and
increases the debt capacity of firms. Applying this principle, long-term assets should be
financed with long term debt, assets with cash flows that move with inflation should be
financed with floating rate debt, assets with cash flows in a foreign currency should be
financed with debt in the same currency, and assets with growing cash flows should be
financed with convertible debt. This matching can be done intuitively, by looking at a
typical project, or can be based upon historical data. Changes in operating income and
value can be regressed against changes in macroeconomic variables to measure the
sensitivity of the firm to these variable. This can then be used to design the optimal
financing vehicle for the firm. Once we identified the right financing vehicle, we have to
make sure that we preserve the tax advantages of debt, and keep equity research analysts
and ratings agencies happy.


Live Case Study
Mechanics of Moving to the Optimal
Objective: To determine whether your firm should move to its optimal mix, and if so,
how, and to analyze the right type of debt for your firm.

Key Questions:
If your firm™s actual debt ratio is different from its “recommended” debt ratio, how

should they get from the actual to the optimal? In particular,
a. should they do it gradually over time or should they do it right now?
b. should they alter their existing mix (by buying back stock or retiring debt), should
they invest in new projects with debt or equity or should they change how much
they return to stockholders?
What type of financing should this firm use? In particular,

a. should the financing be short term or long term?
b. what currency should it be in?
c. what special features should the financing have?

Framework for Analysis
1. The Immediacy Question
If the firm is under levered, does it have the characteristics of a firm that is a

likely takeover target? (Target firms in hostile takeovers tend to be smaller,
have poorer project and stock price performance than their peer groups and
have lower insider holdings)
If the firm is over levered, is it in danger of bankruptcy? (Look at the bond

rating, if the company is rated. A junk bond rating suggests high bankruptcy
2. Alter Financing Mix or Take Proejcts
What kind of projects does this firm expect to have? Can it expect to make

excess returns on these projects? (Past project returns is a reasonable place to
start - see the section under investment returns)
What type of stockholders does this firm have? If cash had to be returned to

them, would they prefer dividends or stock buybacks? (Again, look at the


past. If the company has paid high dividends historically, it will end up with
investors who like dividends)
3. Financing Type
How sensitive has this firm™s value been to changes in macro economic

variables such as interest rates, currency movements, inflation and the
How sensitive has this firm™s operating income been to changes in the same

How sensitive is the sector™s value and operating income to the same

What do the answers to the last 3 questions tell you about the kind of

financing that this firm should use?

Getting Information on mechanics of capital structure
To get the inputs needed to estimate the capital structure mechanics, you can get
the information on macro economic variables such as interest rates, inflation, GNP
growth and exchange rates from my web site. You can get historical information on your
own firm by looking at the Value Line page for your firm, which has information for the
last 15 years on revenues and operating income.
Online sources of information:



1. BMD Inc is a firm with no debt on its books currently and a market value of equity of
$ 2 billion. Based upon its EBITDA of $ 200 million, it can afford to have a debt ratio of
50%, at which level the firm value should be $ 300 million higher.

a. Assuming that the firm plans to increase its leverage instantaneously, what are
some of the approaches it could use to get to 50%?

b. Is there a difference between repurchasing stock and paying a special dividend?
Why or why not?

c. If BMD has a cash balance of $ 250 million at this time, will it change any of
your analysis?

2. MiniSink Inc. is a manufacturing company that has $ 100 million in debt outstanding
and 9 million shares trading at $ 100 per share. The current beta is 1.10, and the interest
rate on the debt is 8%. In the latest year, MiniSink reported a net income of $ 7.50 per
share, and analysts expect earnings growth to be 10% a year for the next 5 years. The
firm faces a tax rate of 40% and pays out 20% of its earnings as dividends (the treasury
bond rate is 7%).

a. Estimate the debt ratio each year for the next 5 years, assuming that the firm maintains
it current payout ratio.

b. Estimate the debt ratio each year for the next 5 years, assuming that the firm doubles
its dividends and repurchases 5% of the outstanding stock every year.

3. IOU Inc. has $ 5 billion in debt outstanding (carrying an interest rate of 9%), and 10
million shares trading at $ 50 per share. Based upon its current EBIT of $ 200 million, its
optimal debt ratio is only 30%. The firm has a beta of 1.20, and the current treasury bond
rate is 7%. Assuming that the operating income will increase 10% a year for the next five
years and that the firm™s depreciation and capital expenditures both amount to $ 100
million annually for each of the five years, estimate the debt ratio for IOU if

a. it maintains its existing policy of paying $ 50 million a year in dividends for the next 5



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