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risks and whether its assets are easily destroyed by ¬nancial distress. Their analy-
sis should focus on:
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• Comparing indicators of business risk for the firm and other firms in its in-
dustry with the economy. Popular indicators of business risk include the ratio
of fixed operating expenses (such as depreciation on plant and equipment) to
sales, the volatility of return on assets, as well as the relation between indica-
tors of the firm™s performance and indicators of performance for the economy
as a whole.
• Examining the competitive nature of the industry. For firms in a highly com-
petitive industry, performance is very sensitive to changes in strategy by
competitors.
• Determining whether the firm™s assets are largely intangible and therefore
sensitive to financial distress, using such ratios as market to book equity.



Determining the Long-Term Optimal Mix of Debt and Equity
The above discussion implies that the optimal mix of debt and equity for a ¬rm can be
estimated by trading off the corporate interest tax shield and monitoring bene¬ts of debt
against the costs of ¬nancial distress. As the ¬rm becomes more highly leveraged, the
costs of leverage presumably begin to outweigh the tax and monitoring bene¬ts of debt.
However, there are several practical dif¬culties in trying to estimate a ¬rm™s optimal
¬nancial leverage. One dif¬culty is quantifying some of the costs and bene¬ts of lever-
age. For example, it is not easy to value the expected costs of ¬nancial distress or any
management incentive bene¬ts from debt. There are no easy answers to this problem.
The best that we can do is to qualitatively assess whether the ¬rm faces free cash ¬‚ow
problems, and whether it faces high business risks and has assets that are easily de-
stroyed by ¬nancial distress. These qualitative assessments can then be used to adjust the
more easily quanti¬ed tax bene¬ts from debt to determine whether the ¬rm™s ¬nancial
leverage should be relatively high, low, or somewhere in between.
A second practical dif¬culty in deciding whether a ¬rm should have high, low, or me-
dium ¬nancial leverage is quantifying what we mean by high, low, and medium. One
way to resolve this question is to use indicators of ¬nancial leverage, such as debt-to-
equity ratios, for the market as a whole as a guide on leverage ranges.
To provide a rough sense of what companies usually consider to be high and low ¬-
nancial leverage, Table 16-2 shows median debt-to-market-equity and debt-to-book-eq-
uity ratios for selected U.S. industries in 1998. Median ratios are reported for all listed
companies and for NYSE companies.
Median debt-to-market-equity ratios are highest for the hotel, steel, and water supply
industries. The core assets for ¬rms in these industries include physical equipment and
property that are readily transferable to debt holders in the event of ¬nancial distress. In
addition, ¬rms in these industries are typically not highly sensitive to economy risk. In
contrast, the software and pharmaceutical industries™ core assets are their research staffs.
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Table 16-2 Median Net Interest-Bearing Debt to Market Equity and Net
Interest-Bearing Debt to Book Equity for Selected U.S. Industries in 1998
Net Interest-Bearing Debt to Net Interest-Bearing Debt to
Market Equity Book Equity
......................................... .........................................

All Listed NYSE All Listed NYSE
Industry Firms Firms Firms Firms
.........................................................................................................................
Computer Software “8% 0% “52% “12%
Pharmaceutical “7% 1% “43% 1%
Retail Stores 3% 46% 13% 75%
Water Supply 50% 49% 100% 108%
Steel Works 85% 46% 55% 38%
Hotels & Motels 107% 75% 126% 108%
.........................................................................................................................


Ownership of these types of assets cannot be easily transferred to debt holders if the ¬rm
is in ¬nancial distress. Researchers are likely to leave for greener pastures if their
budgets are cut. As a result, ¬rms in this industry have relatively conservative capital
structures.
It is also interesting to note that NYSE ¬rms tend to have less extreme leverage than
non-NYSE ¬rms in the same industries. For example, NYSE ¬rms have lower leverage in
the steel and hotel industries, and higher leverage in the software and pharmaceutical in-
dustries than for all ¬rms. The retail industry appears to have relatively low leverage for
all ¬rms but quite high leverage for NYSE ¬rms. This re¬‚ects the fact that NYSE retail
stores tend to be large department stores that offer a broad range of merchandise and are
more likely to be diversi¬ed geographically.
The net debt-to-book-equity ratios by and large tell a similar story to the debt-to-
market-equity ratios. They re¬‚ect the fact that most ¬rms have market-to-book-equity
ratios greater than one both because companies generally invest in projects that add
value for stockholders and because some types of assets, such as R&D, are typically
not re¬‚ected in book equity. Note that this is not true for the steel industry, which has
a negative market-to-book ratio, re¬‚ecting disappointing performance by many ¬rms
in the industry.


THE FINANCING OF NEW PROJECTS
The second model of capital structure focuses on how ¬rms make new ¬nancing deci-
sions. Proponents of this dynamic model argue that there can be short-term frictions in
capital markets which cause deviations from long-run optimal capital structure. One
source of friction arises when managers have better information about their ¬rm™s future
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16-9 Part 3 Business Analysis and Valuation Applications




performance than outside investors. This could lead managers to deviate from their
long-term optimal capital structure as they seek ¬nancing for new investments.
To see how information asymmetries between outside investors and management can
create market imperfections and potentially affect short-term capital structure decisions,
consider management™s options for ¬nancing a proprietary new project that it expects to
be pro¬table. One ¬nancing option is to use retained earnings to cover the investment
outlay. However, what if the ¬rm has no retained earnings available today? If it pays div-
idends, it could perhaps cut dividends to help pay for the project. But as we discuss later,
investors usually interpret a dividend cut as an indication that the ¬rm™s management an-
ticipates poor future performance. A dividend cut is therefore likely to lead to a stock
price decline, which management would probably prefer to avoid. Also, many ¬rms do
not pay dividends.
A second ¬nancing option is to borrow additional funds to ¬nance the project. How-
ever, if the ¬rm is already highly leveraged, the tax shield bene¬ts from debt are likely
to be relatively modest and the potential costs of ¬nancial distress relatively high, mak-
ing additional borrowing unattractive.
The ¬nal ¬nancing option available to the ¬rm is to issue new equity. However, if in-
vestors know that management has superior information on the ¬rm™s value, they are
likely to interpret an equity offer as an indication that management believes that the
¬rm™s stock price is higher than the intrinsic value of the ¬rm.2 The announcement of an
equity offer is therefore likely to lead to a drop in the price of the ¬rm™s stock, raising
the ¬rm™s cost of capital, and potentially leading management to abandon a perfectly
good project.
The above discussion implies that if the ¬rm has internal cash ¬‚ows available or is
not already highly leveraged, it is relatively straightforward for it to arrange ¬nancing
for the new project. Otherwise, management has to decide whether it is worthwhile un-
dertaking the new project, given the costs of cutting dividends, issuing additional debt,
or issuing equity to ¬nance the project. The information costs of raising funds through
these means lead managers to have a “pecking order” for new ¬nancing. Managers ¬rst
use internal cash to fund investments, and only if this is unavailable do they resort to
external ¬nancing. Further, if they have to use external ¬nancing, managers ¬rst use
debt ¬nancing. New equity issues are used only as a last resort because of the dif¬culties
that investors have in interpreting these issues.3
One way for management to mitigate the information problems of using external ¬-
nancing is to ensure that the ¬rm has ¬nancial slack. Management can create ¬nancial
slack by reinvesting free cash ¬‚ows in marketable securities, so that it doesn™t have to
go to the capital market to ¬nance a new project. It could also choose to have relatively
low levels of debt, so that the ¬rm can borrow easily in the future.
In summary, information asymmetries between managers and external investors can
make managers reluctant to raise new equity to ¬nance new projects. Managers™ reluc-
tance arises from their fear that investors will interpret the decision as an indication that
the ¬rm™s stock is overvalued. In the short-term, this effect can lead managers to deviate
from the ¬rm™s long-term optimal mix of debt and equity.
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Corporate Financing Policies




Key Analysis Questions
The above discussion implies that in the short term management should attempt to
¬nance new projects primarily with retained earnings. Further, it suggests that
management would be well advised to maintain ¬nancial slack to ensure that it is
not forced to use costly external ¬nancing. To assess a ¬rm™s ¬nancing options, we
would ask the following types of questions:
• What is the value of current cash reserves (not required for day-to-day work-
ing capital needs) that could be used for new capital outlays? What operating
cash resources are expected to become available in the coming few years? Do
these internal resources cover the firm™s expected cash needs for new invest-
ment and working capital?
• How do the firm™s future cash needs for investment change as its operating
performance deteriorates or improves? Are its investment opportunities rela-
tively fixed, or are they related to current operating cash flow performance?
Investment opportunities for many firms decline during a recession and in-
crease during booms, enabling them to consistently use internal funds for fi-
nancing. However, firms with stable investment needs should build financial
slack during booms so that they can support investment during busts.
• If internal funds are not readily available, what opportunities does the firm
have to raise low-cost debt financing? Normally, a firm which has virtually
zero debt could do this without difficulty. However, if it is in a volatile indus-
try or has mostly intangible assets, debt financing may be costly.
• If the firm has to raise costly equity capital, are there ways to focus investors
on the value of the firm™s assets and investment opportunities to lower any
information asymmetries between managers and investors? For example,
management might be able to disclose additional information about the value
of existing assets, and the uses and expected returns from the new funds.



Summary of Debt Policy
There are no easy ways to quantify the best mix of debt and equity for a ¬rm and its best
¬nancing options. However, some general principles are likely to be useful in thinking
about these questions. We have seen that the bene¬ts from debt ¬nancing are likely to be
highest for ¬rms with:
high marginal tax rates and few noninterest tax shields, making interest tax shields
from debt valuable;
high, stable income/cash ¬‚ows and few new investment opportunities, increasing the
monitoring value of debt and reducing the likelihood that the ¬rm will fall into ¬nan-
cial distress or require costly external ¬nancing for new projects; and
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16-11 Part 3 Business Analysis and Valuation Applications




high tangible assets that are not easily destroyed by ¬nancial distress.
The ¬nancial analysis tools developed in Part 2 of the book are useful in rating a
¬rm™s interest tax shield bene¬ts, its business risk and investment opportunities, and its
major asset types. This information can then be used to judge whether there are bene¬ts
from debt or whether the ¬rm would be better off using equity ¬nancing to support its
business strategies.


FACTORS THAT DETERMINE FIRMS™ DIVIDEND POLICIES
To assess a ¬rm™s dividend policy, analysts typically examine its dividend payout, its
dividend yield, and any stock repurchases. Dividend payout is de¬ned as cash dividends
as a percentage of income available to common shareholders, and re¬‚ects the extent to
which a company pays out pro¬ts or retains them for reinvestment. Dividend yield is div-
idends per share as a percentage of the current stock price, and indicates the current div-
idend return earned by shareholders. Finally, stock repurchases are relevant because
many companies use repurchases of their own stock as an alternative way of returning
cash to shareholders. Table 16-3 provides information on these variables for Merck and
American Water Works.

Table 16-3 Dividend Policy for Merck and American Water Works for the
Year Ended December 31, 1998
American
Merck Water Works
..............................................................................................
Dividend payout 1.3% 2.9%
Dividend yield 44% 55%

Cash dividends $2,253.1m $69.8m
Stock repurchases $3,625.5m $2.4m
..............................................................................................


Merck appears to be following a more conservative dividend policy. It has a lower
payout than American Water Works, and a lower dividend yield. However, Merck also
has a signi¬cant stock repurchase program, whereas American Water Works does not.
After including stock repurchases, Merck effectively paid out more than 100 percent of
its income to shareholders in 1998.
What factors should a ¬rm consider when setting its dividend policy? Do investors
prefer ¬rms to pay out pro¬ts as dividends or to retain them for reinvestment? As we
noted above, many of the factors that affect dividends are similar to those examined in
the section on capital structure decisions. This should not be too surprising, since a
¬rm™s dividend policies also affect its ¬nancing decisions. Thus, dividends provide a
means of reducing free cash ¬‚ow inef¬ciencies. They also have tax implications for in-
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