capital structure planning -...

Giddy/SIM Capital Structure /1

Prof. Ian GiddyNew York University

Capital Structure Planning

SIM/NYUThe Job of the CFO

Copyright ©2001 Ian H. Giddy Capital Structure 3giddy.org

Why Financial Restructuring?

l The Asian Bet

l The Solution, Part I: Recapitalizationl The Solution, Part II: Financial

Restructuring

l The Solution, Part III: Corporate Restructuring



The Asian Bet

l High growth disguised speculative financing structures

l Governments shielded companies and banks from capital market discipline

l Too much debt

l Too much foreign-currency debt

l Closely held ownership relying on reinvested earnings


The Asian Bet

l High growth disguised speculative financing structures

l Governments shielded companies and banks from capital market discipline

l Too much debt

l Too much foreign-currency debt

l Closely held ownership relying on reinvested earnings

The three excessesn Too much debtn Too much laborn Too much capacity

The three excessesn Too much debtn Too much laborn Too much capacity

Example: Hyundai G

roup



How the Bet was Lost

l Vulnerable economies, newly liberalized, succumbed to currency crises

l Economic downturns followed

l Companies were unable to service even domestic debt, never mind foreign currency debt

l Still unreformed, many Asian companies remain misfinanced

Example: Hyundai G

roup


What is Corporate Restructuring?

l Any substantial change in a company’s financial structure, or ownership or control, or business portfolio.

l Designed to increase the value of the firm Restructuring

Improvecapitalization

Change ownershipand control

Improvedebt composition



It’s All About Value

l How can corporate and financial restructuring create value?

Operating

Cash

Flows

Debt

Equity

Assets Liabilities

Fix the business

Or fix the financing


Restructuring

What mix of debt is best suited to this business?

Fix the kind of debt or hybrid financing

What can be done to make the equity more valuable to investors?

Fix the kind of equity

Value the changes new control would produce

Fix management or control

Revalue firm under different leverage assumptions – lowest WACC

Fix the financing – improve D/E structure

Value the merged firm with synergies

Fix the business – strategic partner or merger

Value assets to be soldFix the business mix – divestitures

Use valuation model – present value of free cash flows

Figure out what the business is worth now



Getting the Financing RightStep 1: The Proportion of Equity & Debt

Debt

Equity

n Achieve lowest weighted average cost of capital

n May also affect the business side


Getting the Financing RightStep 2: The Kind of Equity & Debt

Debt

Equity

n Short term? Long term?n Baht? Dollar? Yen?

n Short term? Long term?n Baht? Dollar? Yen?

n Bonds? Asset-backed?n Convertibles? Hybrids?

n Bonds? Asset-backed?n Convertibles? Hybrids?

n Debt/Equity Swaps?n Private? Public?n Strategic partner?n Domestic? ADRs?

n Debt/Equity Swaps?n Private? Public?n Strategic partner?n Domestic? ADRs?

n Ownership & control?n Ownership & control?



Does Capital Structure Matter?

Assets’ value is the present value of the cash flows from the real business of the firm

Value of the firm

=PV(Cash Flows)

Debt

Equity

Value of the firm

= D + E

You cannot change the value of thereal business just by shuffling paper

- Modigliani-Miller


Does Capital Structure Matter? Yes!


Value of the firm

=PV(Cash Flows)

Debt

Equity

Value of the firm

= D + E

COSTOF

CAPITAL

DEBTRATIO

Optimal debt ratio?





Value of the firm

=PV(Cash Flows)

Debt

Equity

Value of the firm

= D + E

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?




Value of the firm

=PV(Cash Flows)

Debt

Equity

Value of the firm

= D + E

Value of Firm= PV(Cash Flows) + PV(Tax Shield) - Distress Costs



Managing the capital base

l Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000

l Flexibility to redeem non-voting shares and buy back ordinary shares

l Flexibility to dispose remaining non-core assets

l Utilizing excess capital for organic growth and acquisitions


Changing Financial Mix

l Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt.

l Taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).

l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt.



Debt: Pros and Cons

Advantages of Borrowing Disadvantages of Borrowing

1. Tax Benefit:

Higher tax rates --> Higher tax benefit

1. Bankruptcy Cost:

Higher business risk --> Higher Cost

2. Added Discipline:

Greater the separation between managers

and stockholders --> Greater the benefit

2. Agency Cost:

Greater the separation between stock-

holders & lenders --> Higher Cost

3. Loss of Future Financing Flexibility:

Greater the uncertainty about future

financing needs --> Higher Cost


See Saw

Business Uncertainty

Financial Risk

Operating Leverage

Financial Leverage



Young and Old

Operating Leverage

Financial Leverage

Operating Leverage

Financial LeverageSize

Maturity


Disney

Weighted Average Cost of Capital and Debt Ratios

Debt Ratio

WA

CC

9.40%

9.60%9.80%

10.00%

10.20%10.40%

10.60%10.80%

11.00%11.20%11.40%

0

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%



Siderar: Steel Company in Argentina

Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G)0% 0.68 16.95% AAA 11.55% 33.45% 7.69% 16.95% $1,046

10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,001

50% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565

0

200

400

600

800

1000

1200

0% 20% 40% 60% 80% 100%

Debt Percentage

Val

ue

($m

illio

ns)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

0% 20% 40% 60% 80% 100%

Debt Percentage

Co

st o

f C

apit

al


Capital Structure: East vs West

VALUE OFTHE

FIRM

DEBTRATIO

Optimal debt ratio?

Intel TPI



Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas


Perceived Benefits to Sammi From Acquisition of Atlas Steel

l Achieve $280mm savings by acquiring Atlas Steel and related companiesuCost of setting up own production facility

would have been $500 mm

uSavings were channeled into restructuring production facilities at existing plants

l Sammi’s share price rose 9% on news of strategic acquisitions



How Should the Acquisition Have Been Financed?

Assets added:$210 million


Debt added:$210 million

(C$250m)


(C$250m)


How Should the Acquisition Have Been Financed?




(C$250m)Loan: C$180m

Ret earn: C$70mPlus w.cap.:

Eurobond withwarrants US$50m


(C$250m)Loan: C$180m

Ret earn: C$70mPlus w.cap.:

Eurobond withwarrants US$50m



Problems faced by Sammi from the Acquisition

l Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages

l Future refinancing of debt caused earnings after interest costs to fall 17%

l Purchase price of $210.6 mm found to have been excessive

l The acquisition was ill-timed

l Existing and new plants suffered from low capacity utilization of around 65%


Sammi Steel in 1995

l Sammi Atlas pushed to raise productivity by 15%l A leaner organization: Work force had shrunk by

19.4% since 1988l 4 year freezes on salaries to limit labor costsl Unrelated and unprofitable businesses have

been sold off

l New export zones identified in China and South-East Asia

l Conversion of debt into equity to reduce interest costs by 6%;

l Result: dilution in EPS, unless offset by increased volume of sales



Analysis of Change in Value of Sammi Steel

( Billions of Korean Won) 1989 1994

Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027

( Billions of Korean Won) 1989 1994

Sales 466 758Operating Profit % of Sales 6.00% 7.00%Net Profit as a % of Sales 2.30% -9.60%Debt / Equity Ratio 1.03 6.72 Market Value of 1 Share 25700 10500KOSPI 909.7 1027


March 1997

Sammi Steel is bankrupt!

ALTO



March 1997

Sammi Steel is bankrupt!

ALTODr F R Structuringn Diagnosisn Preventionn and Cure

Dr F R Structuringn Diagnosisn Preventionn and Cure


Financing Choices


Value of the firm

=PV(Cash Flows)

From

How much debt?

to

What kind of debt?

and

What kind of equity?

You can make a difference- Pepper-Giddy



Corporate Finance

CORPORATE FINANCEDECISONS


INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT

Case Study: “Intralinks”Case Study: “Intralinks”

Prof. Ian GiddyNew York University

Financing Growth Companies



Corporate Finance



INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING

CAPITAL

PORTFOLIO

M&ADEBT EQUITY

TOOLS

MEASUREMENT


The CFO Questions

l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?

l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?

l How much (cheap) debt should we have?

l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?

l How should we manage our financial risks?



Financing X Inc


Financing X Inc



Financing X Inc


Corporate Financing Life-Cycle

Growth companies Mature companies

Leverage



Firm Characteristics as Growth Changes

Variable High Growth Firms tend to Stable Growth Firms tend toRisk be above-average risk be average risk Dividend Payout pay little or no dividends pay high dividendsNet Cap Ex have high net cap ex have low net cap exReturn on Capital earn high ROC (excess return) earn ROC closer to WACCLeverage have little or no debt higher leverage

Earnings

Gearing(Leverage)

0


Financing Growth Companies:The Agenda

l Where can we get the initial equity financing we need to grow?

l Do we want money, management, or more?

l When do we want to sell out, and how?

l When is the right time for debt for a growth company? What kind?



What Kind of Equity?

l Sources of EquityuPrivate investors

uStrategic investors

uInterventionist investors

uPublic market

l And KindsuCommon stock

uStock with restricted voting rights

uHybrids, including convertibles


.comfax (now Messageclick)

l Started in September 1997, .comfax enables users to send faxes and receive faxes over the internet at a low cost.

l By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day.

l Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money.

l What form of equity financing would be appropriate for .comfax?



Pre-IPO Equity Financing

l Friends and family

l Angell Venture capital

l Strategic partners


Pre-IPO Equity Financing

l Friends and family

l Angell Venture capital

l Strategic partners

asiajack.com



Private Equity Funds

l Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring.

l The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.


Silipos Inc



Silipos Inc, 1999

Where do you want

to go?

Debt?Debt?

Acquisition?Acquisition?

IPO?IPO?

Sell?Sell?


IntraLinks



IntraLinks’ Choices

Ø Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.

Ø Seek out one or more private equity investors, ones who believed in the company’s product and its management.

Ø Do an initial public offering (IPO).Ø Find another corporation who would be willing to

acquire IntraLinks.


Why Venture Capitalists Prefer Preferred

l Senior status in bankruptcy

l Does not put a value on the sharesl Is convertible into common stock before

the IPO

l Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero)



Case Study: Photronics



Photronics is the world's leading and fastestgrowing manufacturer of photomasks.Photomasks are high precision quartz plates thatcontain microscopic images of electroniccircuits. A key element and enabling technologyin the manufacture of semiconductors,photomasks are used to transfer circuit patternsonto semiconductor wafers during the fabricationof integrated circuits. They are produced inaccordance with circuit designs provided bycustomers at strategically located manufacturingfacilities in North America, Europe and Asia.




Sales, 1994-99

Balance Sheet, end-1999USD millionsAssets Liabilities & EquityCash 7.6 Current liabilities 50.2Other current assets 59.9 Long term liabilities 132.7Long term assets 319.6 Shareholder's equity 204.2Total 387.1 Total 387.1

Market capitalization 720 P/E 26xEBIT/Int cost 5.77

Book MarketD/E 0.90 0.25D/(D+E) 0.47 0.20


The Company’s Debt



Should Photronics Have More Debt?

l Benefits of DebtuTax Benefits

uAdds discipline to management

l Costs of DebtuBankruptcy Costs

uAgency Costs

uLoss of Future Flexibility


The CFO Questions

l How fast can we grow? What criteria for spending money? Acquisitions? Divestitures?

l How should we finance our growth? What kind of equity? What’s our exit plan? Private or public?

l How much (cheap) debt should we have?

l What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles?

l How should we manage our financial risks?



Some Useful Websites

l giddy.org/jcfo.htm

l giddy.orgl giddyonline.com

l shareinvestor.com

l dialpad.com

l onebox.com


Measuring the Cost of Capital

l Cost of funding equal return that investors expect

l Expected returns depend on the risks investors face (risk must be taken in context)

l Cost of capitaluCost of equity

uCost of debt

uWeighted average (WACC)



A $1 Investment in Different Types of Portfolios: 1926-1996

0.1

1

10

100

1000

10000

1925 1935 1945 1955 1965 1975 1985 1995

Index ($)

$4,495.99

$33.73

$13.54$8.85

$1,370.95

Small Company Stocks

Large Company Stocks

Long-Term Government Bonds

Treasury BillsInflation Year-End


Cashflow to FirmEBIT (1-t)- (Cap Ex - Depr)- Change in WC= FCFF

Expected GrowthReinvestment Rate* Return on Capital

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5

Forever

Firm is in stable growth:Grows at constant rateforever

Terminal Value= FCFFn+1/(r-gn)FCFFn

.........

Cost of Equity Cost of Debt(Riskfree Rate+ Default Spread) (1-t)

WeightsBased on Market Value

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

Value of Operating Assets+ Cash & Non-op Assets= Value of Firm- Value of Debt= Value of Equity

Riskfree Rate :- No default risk- No reinvestment risk- In same currency andin same terms (real or nominal as cash flows

+Beta- Measures market risk X

Risk Premium- Premium for averagerisk investment

Type of Business

Operating Leverage

FinancialLeverage

Base EquityPremium

Country RiskPremium

DISCOUNTED CASHFLOW VALUATION



Let’s Start With the Cost of Debt

l The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components-u(a) The general level of interest rates

u(b) The default premium

u(c) The firm's tax rate


Interest Coverage Ratios, Ratings and Default Spreads

If Interest Coverage Ratio is Estimated Bond Rating Default Spread> 8.50 AAA 0.20%6.50 - 8.50 AA 0.50%5.50 - 6.50 A+ 0.80%4.25 - 5.50 A 1.00%3.00 - 4.25 A– 1.25%2.50 - 3.00 BBB 1.50%2.00 - 2.50 BB 2.00%1.75 - 2.00 B+ 2.50%1.50 - 1.75 B 3.25%1.25 - 1.50 B – 4.25%0.80 - 1.25 CCC 5.00%0.65 - 0.80 CC 6.00%0.20 - 0.65 C 7.50%< 0.20 D 10.00%



Other Factors Affecting RatiosMedians of Key Ratios : 1993-1995

AAA AA A BBB BB B CCCPretax Interest Coverage 13.50 9.67 5.76 3.94 2.14 1.51 0.96

EBITDA Interest Coverage 17.08 12.80 8.18 6.00 3.49 2.45 1.51Funds from Operations / Total Debt

(%) 98.2% 69.1% 45.5% 33.3% 17.7% 11.2% 6.7%

Free Operating Cashflow/ TotalDebt (%) 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96%

Pretax Return on Permanent Capital(%) 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2%

Operating Income/Sales (%) 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2%Long Term Debt/ Capital 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5%Total Debt/Capitalization 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1%


Estimating Siderar’s Cost of Debt (in $)

l Riskfree Rate = 6%l Country default spread = 5.25%

(Argentine default spread)uI am assuming that all Argentine

companies have to pay at least this spread.

l Rating for Siderar = A-l Default spread = 1.25%l Pre-tax cost of borrowing for first 5

years= 6% + 5.25% + 1.25% = 12.50%



The Cost of Equity

Equity is not free!

Expected return = Risk-free rate + Risk Premium

E(RRisky) = RRisk-free -+ Risk Premium


The Cost of Equity

l Consider the standard approach to estimating cost of equity:Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)

where,Rf = Riskfree rateE(Rm) = Expected Return on the Market Index (Diversified Portfolio)

l In practice,u Short term government security rates are used as risk free

ratesu Historical risk premiums are used for the risk premium

u Betas are estimated by regressing stock returns against market returns



Private Business: Owner hasall his wealth invested in thebusiness

Venture Capitalist: Haswealth invested in a numberof companies in one sector

Publicly traded companywith investors who are diversified domesticallyorIPO to investors who aredomestically diversified

Publicly traded companywith investors who are diverisified globallyorIPO to global investors

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

Market Risk

Int’nl Risk

Sector Risk

Competitive Risk

Project Risk

TotalRisk

Risk added to sectorportfolio

Risk added to domestic portfolio

Risk added to global portfolio

StandardDeviation

Beta relative to sector

Beta relative to local index

Beta relative to global index

40%

25%

15%

10%

100/.4=250

100/.25=400

100/.15=667

100/.10=1000

Investor Type Cares about Risk Measure Cost ofEquity

Firm Value

Valuing a Firm from Different Risk PerspectivesFirm is assumed to have a cash flow of 100 each year forever.


The Cost of Capital

Choice Cost1. Equity Cost of equity- Retained earnings - depends upon riskiness of the stock- New stock issues - will be affected by level of interest rates- Warrants

Cost of equity = riskless rate + beta * risk premium

2. Debt Cost of debt- Bank borrowing - depends upon default risk of the firm- Bond issues - will be affected by level of interest rates

- provides a tax advantage because interest is tax-deductible

Cost of debt = Borrowing rate (1 - tax rate)

Debt + equity = Cost of capital = Weighted average of cost of equity andCapital cost of debt; weights based upon market value.

Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]



Estimating Cost of Capital: Siderar

l EquityuCost of Equity = 6.00% + 0.71 (16.03%) = 17.38%uMarket Value of Equity = 3.20* 310.89 = 995 million

(94.37%)

l DebtuCost of debt = 6.00% + 5.25% + 1.25% (default spread)

= 12.5%uMarket Value of Debt = 59 Mil (5.63%)

l Cost of CapitalCost of Capital = 17.38%(.9437) + 12.5%(1-.3345)(.0563))

= 17.38%(.9437) + 8.32%(.0563) = 16.87%


Next, Minimize the Cost of Capital by Changing the Financial Mix

l The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm.

l Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt.

l But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).

l The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.



This is What We’re Trying to Do

D/(D+E) ke kd After-tax Cost of Debt WACC

0 10.50% 8% 4.80% 10.50%

10% 11% 8.50% 5.10% 10.41%

20% 11.60% 9.00% 5.40% 10.36%

30% 12.30% 9.00% 5.40% 10.23%

40% 13.10% 9.50% 5.70% 10.14%

50% 14% 10.50% 6.30% 10.15%

60% 15% 12% 7.20% 10.32%

70% 16.10% 13.50% 8.10% 10.50%

80% 17.20% 15% 9.00% 10.64%

90% 18.40% 17% 10.20% 11.02%

100% 19.70% 19% 11.40% 11.40%


Cost of Capital and Leverage: Method

Estimated BetaWith current leverage

From regression

Unlevered BetaWith no leverage

Bu=Bl/(1+D/E(1-T))

Levered BetaWith different leverage

Bl=Bu(1+D/E(1-T))

Cost of equityWith different leverage

E(R)=Rf+Bl(Rm-Rf)

Equity

Leverage, EBITDAAnd interest cost

Interest CoverageEBITDA/Interest

Rating(other factors too!)

Cost of debtWith different leverage

Rate=Rf+Spread+?

Debt



Siderar: Optimal Debt Ratio


10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,00150% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565

Question: If Siderar’s current debt ratio is 60%, what do you recommend?


Siderar: Optimal Debt Ratio


10% 0.73 17.76% AA 11.95% 33.45% 7.95% 16.78% $1,06420% 0.80 18.77% A- 12.75% 33.45% 8.49% 16.71% $1,07130% 0.88 20.07% B+ 14.25% 33.45% 9.48% 16.90% $1,05240% 0.99 21.81% B- 16.25% 33.45% 10.81% 17.41% $1,001

50% 1.14 24.24% CCC 17.25% 33.45% 11.48% 17.86% $96160% 1.44 29.16% CC 18.75% 25.67% 13.94% 20.02% $80370% 1.95 37.29% C 20.25% 20.38% 16.12% 22.47% $67480% 2.93 52.94% C 20.25% 17.83% 16.64% 23.90% $61590% 5.86 99.87% C 20.25% 15.85% 17.04% 25.32% $565

0

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0% 20% 40% 60% 80% 100%

Debt Percentage

Val

ue

($m

illio

ns)

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

0% 20% 40% 60% 80% 100%

Debt Percentage

Co

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f C

apit

al



A Framework for Getting to the Optimal

Is the actual debt rat io greater than or lesser than the opt imal debt rat io?

Actual > Opt imalOver levered

Actual < Opt imalUnder levered

Is the f i rm under bankruptcy threat? Is the f i rm a takeover target?

Yes No

Reduce Debt qu ick ly1. Equi ty for Debt swap2. Sel l Assets; use cashto pay of f debt3. Renegot ia te wi th lenders

Does the f i rm have good projects?ROE > Cost o f Equi tyROC > Cost o f Capi ta l

Yes

Take good pro jects wi thnew equi ty or wi th retainedearnings.

No

1. Pay of f debt wi th retainedearnings.2. Reduce or e l iminate d iv idends.3 . Issue new equ i ty and pay o f f debt.

Yes No

Does the f i rm have good projects?ROE > Cost o f Equi tyROC > Cost o f Capi ta l

YesTake good pro jects wi thdebt.

No

Do your s tockholders l ikediv idends?

YesPay Div idends No

Buy back stock

Increase leveragequickly1. Debt /Equi ty swaps2 . Bor row money&buy shares.


giddy.org

Ian GiddyNYU Stern School of Business

Tel 212-998-0332

Fax 917-463-7629

[email protected]

http://giddy.org

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