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Works, a large utility, for the year ended December 31, 1998, reported in Table 16-1.



16-1




651
652 Corporate Financing Policies




16-2
Corporate Financing Policies




Table 16-1 Net Interest-Bearing Debt for Merck and American Water
Works for the Year ended December 31, 1998
American
Merck Water Works
.........................................................................................................................
Interest-bearing debt $ 3,220.8 $,2247.9
Less: cash and short-term investments 3,355.7 39.1
Net debt (134.9) 2,208.8
Book shareholders™ equity 12,801.8 1,290.9
Net interest-bearing debt to book equity “1% 171%
.........................................................................................................................

Merck actually has more liquid assets (cash and marketable securities) than debt. As
a result, it has almost no net debt. In contrast, American Water Works has a ratio of net
debt to book equity of 171 percent. Throughout the chapter we will examine factors that
are relevant to the ¬nancing differences for these ¬rms.
When ¬nancial analysts evaluate a ¬rm™s capital structure, two related questions typ-
ically emerge. First, in the long term, what is the best mix of debt and equity for creating
stockholder value? And second, if managers are considering new investment initiatives
in the short-term, what type of ¬nancing should they use? Two popular models of capital
structure provide help in thinking about these questions. The static model of capital
structure examines how trade-offs between the bene¬ts and costs of debt determine a
¬rm™s long-term optimal mix of debt and equity. And the dynamic model examines how
information effects can lead a ¬rm to deviate from its long-term optimal capital structure
as it seeks ¬nancing for new investments. We discuss both models, since they have
somewhat different implications for thinking about capital structure.


THE OPTIMAL LONG-TERM MIX OF DEBT AND EQUITY
To determine the best long-term mix of debt and equity capital for a ¬rm, we need to
consider the bene¬ts and costs of ¬nancial leverage. By trading off these bene¬ts and
costs, we can decide whether a ¬rm should be ¬nanced mostly with equity or mostly
with debt.


Benefits of Leverage
The major bene¬ts of ¬nancial leverage typically include corporate tax shields on inter-
est and improved incentives for management.

CORPORATE INTEREST TAX SHIELDS. In the U.S., and in many other countries
for that matter, tax laws provide a form of government subsidy for debt ¬nancing which
does not exist for equity ¬nancing. This arises from the corporate tax deductibility of in-
653
Corporate Financing Policies




16-3 Part 3 Business Analysis and Valuation Applications




terest against income. No such corporate tax shield is available for dividend payments
or for retained earnings. Debt ¬nancing therefore has an advantage over equity, since the
interest tax shields under debt provide additional income to debt and equity holders. This
higher income translates directly into higher ¬rm values for leveraged ¬rms in relation
to unleveraged ¬rms.
Some practitioners and theorists have pointed out that the corporate tax bene¬t from
debt ¬nancing is potentially offset by a personal tax disadvantage of debt.1 That is, since
the holders of debt must pay relatively high tax rates on interest income, they require that
corporations offer high pretax yields on debt. This disadvantage is particularly severe
when interest income is taxed at a higher rate than capital gains on equity. However, un-
der current U.S. tax laws, personal tax rates on interest income and capital gains are
identical, implying that personal tax effects are unlikely to eliminate the corporate tax
bene¬ts of debt.
Therefore, the corporate tax bene¬ts from debt ¬nancing should encourage ¬rms
with high effective tax rates and few forms of tax shield other than interest to have highly
leveraged capital structures. In contrast, ¬rms that have tax shield substitutes for inter-
est, such as depreciation, or that have operating loss carryforwards and hence do not ex-
pect to pay taxes, should have capital structures that are largely equity.


Key Analysis Questions
To evaluate the tax effects of additional debt, analysts can use accounting, ¬nan-
cial ratio, and prospective analysis to answer the following types of questions:
• What is a firm™s average income tax rate? How does this rate compare with
the average tax rate and financial leverage for its major competitors?
• What portion of a firm™s tax expense is deferred taxes versus current taxes?
• What is the firm™s marginal corporate tax rate likely to be?
• Does the firm have tax loss carryforwards or other tax benefits? How long are
they expected to continue?
• What noninterest tax shields are currently available to the firm? For example,
are there sizable tax shields from accelerated depreciation?
• Based on pro forma income and cash flow statements, what are our estimates
for the firm™s taxable income for the next five to ten years? What noninterest
tax shields are available to the firm? Finally, what would be the tax savings
from using some debt financing?



MANAGEMENT INCENTIVES FOR VALUE CREATION. A second bene¬t of debt
¬nancing is that it focuses management on value creation, thus reducing con¬‚icts of in-
terest between managers and shareholders. Con¬‚icts of interest can arise when manag-
ers make investments that are of little value to stockholders and/or spend the ¬rm™s
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16-4
Corporate Financing Policies




funds on perks, such as overly spacious of¬ce buildings and lavish corporate jets. Firms
are particularly prone to these temptations when they are ¬‚ush with cash but have few
promising new investment opportunities, often referred to as a “free cash ¬‚ow” situa-
tion. These ¬rms™ stockholders would generally prefer that their managers pay out any
free cash ¬‚ows as dividends or use the funds to repurchase stock. However, these op-
tions reduce the size of the ¬rm and the assets under management™s control. Manage-
ment may therefore invest the free cash ¬‚ows in new projects, even if they are not valued
by stockholders, or spend the cash ¬‚ows on management perks.
How can debt help reduce management™s incentives to overinvest and to overspend
on perks? The primary way is by reducing resources available to fund these types of out-
lays, since ¬rms with relatively high leverage face pressures to generate cash ¬‚ows to
meet payments of interest and principal.
The debt introduced as a result of the 1988 leveraged buyout of RJR Nabisco was
viewed by many as an example of debt creating pressure for management to refocus on
value creation for stockholders. Under this view, the incentive problems facing the com-
pany stemmed from the high cash ¬‚ows it generated in the tobacco business and the low
investment opportunities in this line of business given the decline in popularity of smok-
ing in the U.S. The increased debt taken with the LBO forced RJR Nabisco™s manage-
ment to eliminate unnecessary perks, such as corporate jets and parties with famous
sports stars, to slow diversi¬cation into the food industry, and to cancel unpro¬table
projects such as the smokeless cigarette.


Key Analysis Questions
Financial ratio and prospective analysis can help analysts assess whether there are
currently free cash ¬‚ow inef¬ciencies at a ¬rm as well as risks of future inef¬cien-
cies. Symptoms of excessive management perks and investment in unpro¬table
projects include the following:
• Does the firm have high ratios of general and administrative expenses and
overhead to sales? If its ratios are higher than those for its major competitors,
one possibility is that management is wasting money on perks.
• Is the firm making significant new investments in unrelated areas? If it is dif-
ficult to rationalize these new investments, there might be a free cash flow
problem.
• Does the firm have high levels of expected operating cash flows (net of essen-
tial capital expenditures and debt retirements) from pro forma income and
cash flow statements?
• Does the firm have poor management incentives to create additional share-
holder value, evidenced by a weak linkage between management compensa-
tion and firm performance?
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16-5 Part 3 Business Analysis and Valuation Applications




Costs of Leverage: Financial Distress
As a ¬rm increases its leverage, it increases the likelihood of ¬nancial distress, where it
is unable to meet interest or principal repayment obligations to creditors. This may force
the ¬rm to declare bankruptcy or to agree to restructure its ¬nancial claims.
Financial distress can be expensive, since restructurings of a ¬rm™s ownership claims
typically involve costly legal negotiations. It can also be dif¬cult for distressed ¬rms to
raise capital to undertake pro¬table new investment opportunities. Finally, ¬nancial dis-
tress can intensify con¬‚icts of interest between stockholders and the ¬rm™s debtholders,
increasing the cost of debt ¬nancing.

LEGAL COSTS OF FINANCIAL DISTRESS. When a ¬rm is in serious ¬nancial dis-
tress, its owners™ claims are likely to be restructured. This can take place under formal
bankruptcy proceedings or out of bankruptcy. Restructurings are likely to be costly,
since the parties involved have to hire lawyers, bankers, and accountants to represent
their interests, and they have to pay court costs if there are formal legal proceedings.
These are often called the direct costs of ¬nancial distress.

COSTS OF FORGONE INVESTMENT OPPORTUNITIES. When a ¬rm is in ¬nancial
distress and particularly when it is in bankruptcy, it may be very dif¬cult for it to raise
additional capital for new investments, even though they may be pro¬table for all the
¬rm™s owners. In some cases, bankrupt ¬rms are run by court-appointed trustees, who
are unlikely to take on risky new investments”pro¬table or not. Even for a ¬rm whose
management supports new investment, the ¬rm is likely to be capital constrained. Cred-
itors are unlikely to approve the sale of nonessential assets unless the proceeds are used
to ¬rst repay their claims. Potential new investors and creditors will be wary of the ¬rm
because they do not want to become embroiled in the legal disputes themselves. Thus,
in all likelihood the ¬rm will be unable to make signi¬cant new investments, potentially
diminishing its value.

COSTS OF CONFLICTS BETWEEN CREDITORS AND STOCKHOLDERS. When
a ¬rm is performing well, both creditors™ and stockholders™ interests are likely to coin-
cide. Both want the ¬rm™s managers to take all investments which increase the value of
the ¬rm. However, when the ¬rm is in ¬nancial dif¬culty, con¬‚icts can arise between
different classes of owners. Creditors become concerned about whether the ¬rm will be
able to meet its interest and principal commitments. Shareholders become concerned
that their equity will revert to the creditors if the ¬rm is unable to meet its outstanding
obligations. Thus, managers are likely to face increased pressure to make decisions
which serve the interests of only one form of owner, typically stockholders, rather than
making decisions in the best interests of all owners. For example, managers have incen-
tives to issue additional debt with equal or higher priority, to invest in riskier assets, or
to pay liquidating dividends, since these actions reduce the value of outstanding credi-
tors™ claims and bene¬t stockholders. When it is costly to completely eliminate this type
656 Corporate Financing Policies




16-6
Corporate Financing Policies




of game playing, creditors will simply reduce the amount they are willing to pay the ¬rm
for the debt when it is issued, increasing the costs of borrowing for the ¬rm™s stock-
holders.

OVERALL EFFECTS OF FINANCIAL DISTRESS. The costs of ¬nancial distress dis-
cussed above offset the tax and monitoring bene¬ts of debt. As a result, ¬rms that are
more likely to fall into ¬nancial distress or for which the costs of ¬nancial distress are
especially high should have relatively low ¬nancial leverage. Firms are more likely to
fall into ¬nancial distress if they have high business risks, that is, if their revenues and
earnings before interest are highly sensitive to ¬‚uctuations in the economy. Financial
distress costs are also likely to be relatively high for ¬rms whose assets are easily de-
stroyed in ¬nancial distress. For example, ¬rms with human capital and brand intangi-
bles are particularly sensitive to ¬nancial distress since dissatis¬ed employees and
customers can leave or seek alternative suppliers. In contrast, ¬rms with tangible assets
can sell their assets if they get into ¬nancial distress, providing additional security for
lenders and lowering the costs of ¬nancial distress. Firms with intangible assets are
therefore less likely to be highly leveraged than ¬rms whose assets are mostly tangible.
These factors probably largely explain why Merck and American Water Works, the
two companies discussed at the beginning of the chapter, have such different ¬nancing
policies. Merck probably keeps its leverage low because many of its core assets are in-
tangibles, such as research staff and sales force representatives. These types of assets can
easily be lost if Merck gets into ¬nancial dif¬culty as a result of too much leverage. In
all likelihood, management would be forced to cut back on R&D and marketing, leading
the most talented researchers and sales representatives to be attracted by offers from
competitors. Merck can reduce these risks by having very low leverage.
In contrast, American Water Works is a utility. It has very stable cash ¬‚ows since its
revenues are regulated. In addition, its major asset is its physical plant, which is less
likely to diminish in value if it gets into ¬nancial distress. If the debt holders ended up
as the new owners of the ¬rm following ¬nancial distress, they could continue to use the
existing assets. American Water Works can therefore take advantage of the tax bene¬ts
from corporate debt without bearing a high cost of ¬nancial distress.


Key Analysis Questions
The above discussion implies that a ¬rm™s optimal ¬nancial leverage will depend
on its underlying business risks and asset types. If the ¬rm™s business risks are rel-
atively high or its assets can be easily destroyed by ¬nancial distress, changing the
mix of debt and equity toward more debt may actually destroy shareholder value.
Analysts can use ratio, cash ¬‚ow, and pro forma analysis to assess a ¬rm™s business

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