Capital structure the financing details
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Capital Structure: The Financing Details. 05/21/08 Ch. 9. Capital structure changes. If a firm’s debt ratio is different from its optimal debt ratio the firm has to decide whether to Move towards the optimal Move quickly or gradually. Should a firm change its capital structure?.

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Capital Structure: The Financing Details

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Capital structure the financing details

Capital Structure: The Financing Details

05/21/08

Ch. 9


Capital structure changes

Capital structure changes

  • If a firm’s debt ratio is different from its optimal debt ratio the firm has to decide whether to

    • Move towards the optimal

    • Move quickly or gradually


Should a firm change its capital structure

Should a firm change its capital structure?

  • Reasons for maintaining a sub-optimal debt ratio:

    • Underlevered firms

      • Adding debt may add restrictions (through debt covenants) to what a firm can do. Firms that value flexibility may choose not to use their excess capacity

      • Firms with greater uncertainty about future financing needs may also value flexibility

    • Overlevered firms

      • Government protection (from bankruptcy) may allow firms to stay overlevered without facing the costs of default


Gradual versus immediate change

Gradual versus immediate change

  • How confident is the firm about the optimal leverage estimate?

  • How does the firm’s current debt ratio compare to that of the industry?

  • For underlevered firms,

    • What is the likelihood of takeover?

    • Does the firm need financial flexibility?

  • For overlevered firms,

    • What is the likelihood of bankruptcy?


  • Implementing changes in financial mix

    Implementing changes in financial mix

    • Recapitalization – firms change their financing mix on current projects by using new equity to retire debt or new debt to reduce equity. This can be done by

      • Borrowing money and buying back stock

      • Conducting a debt-for-equity swap, where a firm replaces equity with debt of equivalent market value

      • Issuing new equity and using the proceeds to pay off some of its outstanding debt


    Implementing changes in financial mix1

    Implementing changes in financial mix

    • Divestiture

      • Selling firm assets and using the proceeds to reduce debt or equity.

      • Firms will typically sell the worse performing assets for this purpose.


    Implementing changes in financial mix2

    Implementing changes in financial mix

    • Financing new investments

      • Firms can change their debt ratio by financing new investments disproportionately with new debt or equity.

      • This process will gradually change the debt ratio.


    Implementing changes in financial mix3

    Implementing changes in financial mix

    • Changing dividend payout

      • Increasing the proportion of earnings paid out as dividends will increase the debt ratio.


    Choosing between the alternatives

    Choosing between the alternatives

    • Urgency of change

    • Quality of new investments – does the firm have good projects that will allow them to alter their debt ratio?

    • Marketability of existing investments – does the firm have assets that do not earn excess returns and that can be sold at a fair price?


    A framework for analyzing a company s capital structure

    A framework for analyzing a company’s capital structure

    Is the actual debt ratio greater than or lesser than the optimal debt ratio?

    Actual > Optimal

    Actual < Optimal

    Overlevered

    Underlevered

    Is the firm a takeover target?

    Is the firm under bankruptcy threat?

    Yes

    No

    Yes

    No

    Does the firm have

    marketable investments?

    Does the firm have

    marketable investments?

    Does the firm have good

    Projects?

    Yes - Divestiture

    Sell assets and buy

    back stock

    Yes - Divestiture

    Sell assets and retire

    debt

    No – Recapitalization

    1. Debt/equity swap

    2. Borrow money,

    buy back shares

    No - Recapitalization:

    1. Equity for debt swap

    2. Renegotiate with lenders

    Does the firm have good

    projects? (Positive NPV)

    No

    Yes

    Take good projects with

    debt

    Yes

    No

    Do your stockholders like

    dividends?

    Take good projects with new equity or with retained earnings.

    1. Pay off debt with retained earnings

    2. Reduce or eliminate dividends

    3. Issue new equity and pay off debt

    No - Buy back

    stock

    Yes - Pay Dividends


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