Chapter 16

(1) Apply the concepts discussed in Chapter 15 to choose a firm's capital structure.

(2) Explain why a firm's senior debt rating serves as a useful indicator of the firm's exposure to default risk.

(3) Use a firm's choice of senior debt rating to help it choose and manage its capital structure.

(5) Calculate the cost of capital for a firm or capital budgeting project when the firm follows a policy of leverage rebalancing each period on the basis of realized market value.

(1) The behavioral principle suggests that managers will follow the industry practice whenever in doubt as to what is appropriate behavior.

(b) This is because we find systematic differences in capital structures across industries.

(i) There are differences in operating risk across firms; everything else being the same, firms with more operating risk will choose less debt.

(ii) The availability of tax shelter provided by things other than debt, such as accelerated depreciation, investment tax credits, and operating tax loss carryforwards.

(iii) The ability of assets to support borrowing (by being liquid and valuable in themselves).

(2) Firms should not blindly follow the industry norm. This is because significant differences among firms in the same industry can exist in terms of tax position, size, competitive position, operating risk, business prospects, and other factors.

(3) In practice, a firm's bond rating has important implications for the choice of capital structure.

(a) Moody's Investors Service, Inc. and Standard & Poor's Corporation are two major rating agencies.

(c) Investment grade ratings are the four top ratings. The other ratings are speculative with the lower ratings indicating more speculative.

(4) The distinction between investment grade and speculative grade ratings is important because of institutional investment restrictions.

(a) Various state laws impose minimum rating stands and other restrictions that bonds must meet to qualify as legal investments for savings banks, trust firms, public pension funds, and insurance companies.

(b) Bonds rated speculative grade do not qualify as legal investments for many financial institutions including commercial banks.

(a) Such a choice involves a decision about the chance of future financial distress.

(b) The choice also depends on the firm's desire to maintain access to the capital markets.

(1) There are five basic considerations involved in a firm's choice of capital structure: ability to service debt; ability to use interest tax shields fully; protection against illiquidity; desired degree of access to capital markets; and dynamic factors and debt management over time.

(2) The first basic consideration when choosing a capital structure is the ability to service debt.

(i) The interest coverage ratio = EBIT/(Interest Expense) where interest expense can include rental payments such as leases.

(ii) The fixed-charge coverage ratio = [EBIT + (Rentals/3)] / [Interest Expense + (Rentals/3)] where dividing rentals by 3 is an attempt to approximate the interest component of rental expense as given by the SEC.

(iii) The debt-service coverage ratio = [EBIT + (Rentals/3)] / [Interest Expense + rentals/3 + (Principal Repayments/{1 - Tax Rate})] where the amount of principal repayments is divided by 1 minus the tax rate, because principal repayments are not tax deductible.

(b) Higher rated firms will have higher coverage ratios. Also firms with higher levels of operating leverage should set higher coverage ratios.

(3) The second basic consideration when choosing a capital structure is the ability to use interest tax shields fully.

(a) Firms that use debt financing must generate sufficient income from operations to claim the interest deductions.

(b) Firms in industries with other substantial tax shelter opportunities, such as oil and gas companies (with their depletion allowances) and steelmakers (with their depreciation and loss carryforwards), should have lower leverage ratios than firms in other industries.

(c) The tax value of incremental interest deductions varies significantly across industries because of differences in nondebt tax shield.

(4) The third basic consideration when choosing a capital structure is the ability of assets to support debt.

(a) A firm should not incur additional debt if doing so would involve a significant chance of insolvency.

(b) Lower risk more generic, more tangible assets with more stable market values provide better collateral for debt.

(5) The fourth basic consideration when choosing a capital structure is the desired degree of access to capital markets.

(a) To maintain access to the capital markets on acceptable terms, the firm must maintain an adequate credit strength.

(b) Acceptable terms for many firms means maintaining a senior debt rating of single-A or better (which is investment grade).

(6) The fifth basic consideration when choosing a capital structure is the corporate debt management over time.

(a) A firm might appear to deviate from the normal financing preference order due to the costs of issuing securities.

(b) A firm that issues equity to maintain dividends may "stray" from its target in order to finance a good project.

(1) A comparative credit analysis suggests a range of target capital structures that might be appropriate.

(a) The approach bases a firm's choice of capital structure on the capital structures of other comparable firms whose senior debt carries the desired bond rating.

(b) This method involves three steps: select the desired rating objective; identify a set of comparable firms that also have the target senior debt rating; and, perform a comparative credit analysis of these firms to define the capital structure (or range of capital structures) most consistent with this rating objective.

(2) A pro forma capital structure analysis shows the impact of the alternatives within the target range on the firm's credit statistics and reported financial results and it indicates whether the firm will be able to use tax shield benefits fully. This enables the firm to select a specific target capital structure.

(3) In practice, firms adopt complex capital structures that include more than just common stock and investment grade debt.

(a) For example, there are various types of debt including subordinated debt, convertible debt, and capitalized lease obligations.

(b) In addition, preferred stock can be chosen (it is a hybrid security combining both debt features and common stock features).

(1) A firm's adjusted WACC reflects the firm's capital structure in addition to the project's risk.

(2) Since a required rate of return is an opportunity cost of capital (and not a historical cost), each project's return should be based on considerations today.

(a) A project's WACC can always be represented as the weighted average of the market value proportions of any debt and equity financing package that will allow the project to be undertaken.

(b) Recall that WACC = (1-L)r_e + L(1-T)r_d where T is the relevant corporate tax rate, r_d is the required return on debt, and r_e is the required return on equity.

(c) Both required rates of return are specific to the projects. They depend upon tax laws, asymmetric information considerations, and transaction costs associated with a given capital structure.

(3) The effect of capital structure on value is based on the entire firm's financing.

(a) Therefore, the project's cost of capital must be adjusted on the same basis.

(b) The impact of financing on the project's cost of capital is determined by the capital structure of the whole firm.

(4) There are two situations in which it is particularly important to adjust explicitly for capital structure effects.

(a) The first is when the repayment of a loan is tied to one or more specific assets. Leverage will change as the loan is repaid and as the asset is used up and its value declines.

(b) The second case occurs in practice when firms adjust their leverage to coincide with their target capital structures. This is called leverage rebalancing and it adds an element of risk that affects the cost of capital.

(1) The adjusted present value (APV) method adjusts for the effect of capital structure for projects that have finite lives. It is very useful in situations where the financing and investment are tied together, such as leases and leveraged buyout.

(2) Each projects's value can be expressed similarly to a firm value, for example, as the sum of two components.

(a) The two components are the "basic" project income and the net benefit from debt financing.

(b) The formula is: APV₀ = CFAT₁/(1+r)¹ + T*INT₁/(1+r_d)¹ + CFAT₂/(1+r)² + T*INT₂/(1+r_d)² + ... + CFAT_n/(1+r)ⁿ + T*INT_n/(1+r_d)ⁿ.

(1) Even when the firm's financing decisions are separate from its capital budgeting decisions, if T* is positive, capital structure affects the value of the firm's investments. To include that value effect, we must know the pattern of debt payments.

(2) Leverage rebalancing takes place when a firm tries to make its current leverage ratio (L) the same as its target (L*).

(3) When leverage is rebalanced each period on the basis of the realized market value, the net benefit to leverage in futures periods will vary with the value of the project.

(a) With leverage rebalancing, the present value of the net benefits to leverage is not determined by r_d.

(b) Only the net benefit from the first period is discounted at r_d, because only the first period's debt is known at the start (t = 0).

(c) The net benefit to leverage in later periods must be discounted at r, the project's unleveraged required return, because this net benefit will vary as the project value varies in future periods.

(4) With level perpetual income, there is a "basic" expected after-tax cash flows, CFAT, of I(1-T) each period. There is also an expected net benefit to leverage each period of T*Lr_dE(V_L) where E(V_L) is the expected value of the project.

(a) To compute the present values of each cash flow, we need to know the required return for each income stream. The first stream has the unleveraged require return, r. The second stream is discounted by r_d for the first period but by a rate that is riskier for each future period depending on the project's value (thus, it is r).

(5) The present value of the net benefit to leverage is: PV(net benefit to leverage) = [+(h/r)]/(1+r_d) where = T*Lr_dV_L and h = T*Lr_dE(V_L).

(a) We discount the cash flows of and h/r by (1+r_d) because they occur at t=1 and are the same risk as debt.

(b) The perpetual cash flow, h, starts at t=2 and so the perpetuity is valued at t=1.

(c) I is a level expected perpetuity. Its expected value at any future point in time is the same as its current expected value. Therefore E(V_L) = V_L and h is the same as .

(d) Thus, we can substitute T*Lr_dV_L for both and h. Making these substitutions and rearranging terms gives the total value of the leveraged investment: V_L = I(1-T)/{r - [T*Lr_d(1+r)/(1+r_d)]} where the denominator, {r - [T*Lr_d(1+r)/(1+r_d)]}, is WACC when a firm follows a policy of leverage rebalancing each period on the basis of the investment's realized market value.

(e) Setting H = T*Lr_d/(1+r_d), then WACC = {r - [H(1+r_d)]}. Solving for r, we have r = (WACC+H)/(1-H). Knowing WACC from the standard formula where WACC = (1-L)r_e + L(1-T)r_d we can find r.

(1) The first step for estimating WACC is to choose one or more comparable firms that are similar to the project in risk and industry characteristics and have publicly traded securities.

(2) The second step is to estimate values in the WACC formula for each comparable firm.

(a) Estimate L by dividing the total market value of the firm's debt by the sum of the total market values of the firm's debt and equity.

(b) Estimate r_d by estimating the yield to maturity on the firm's outstanding debt.

(e) Estimate the net-benefit-to-leverage factor for the firm, T*, which involves considering the firm's marginal tax rate, the uniqueness of its products, and the amount of nondebt tax shield, among other factors. Empirical research suggests that most estimates for a healthy firm fall somewhere between 0.05 and 0.25.

(3) The third step is to use the parameter estimates in the previous step to estimate H, WACC, and r.

(4) The fourth step is to use from the previous step the estimates of r from comparable firms to estimate a single r for the project reflecting its business risk.

(5) The fifth step is to estimate the project's WACC (which includes both business risk and the effects of capital structure) by using WACC = r - [T*Lr_d(1+r)/(1+r_d)] where r is given in the previous step and following estimates for the firm that is considering the investment.

(A2) What is the major reason why subordinated debt is typically rated lower than senior debt?

The major reason that subordinated debt is typically rated lower than senior debt is that subordinated debt has a greater exposure to default risk.

(A3) A firm's latest 12 months' EBIT is $30M (M = million), and its interest expense for the same period is $10M. Calculate the interest coverage ratio.

(A4) The firm in Problem A3 also had $15M of rental expense during the latest 12 months. Calculate the firm's fixed-charge coverage ratio.

Fixed-charge coverage ratio = [EBIT + (Rentals/3)] / [Interest Expense + (Rentals/3)] = [$30M + ($15M/3)] / [$10M + ($15M/3)] = 2.33.

[NOTE. Dividing rentals by 3 is an attempt to approximate the interest component of rental expense as given by the SEC.]

(A5) The firm in Problems A3 and A4 also had $6M of principal repayments during the latest 12 months. Its marginal tax rate is 40%. Calculate the debt-service coverage ratio.

Debt-service coverage ratio = [EBIT + (Rentals/3)] / [Interest Expense + (Rentals/3) + (Principal Repayments/{1 - Tax Rate})] = [$30M + ($15M/3)] / [$10M + ($15M/3) + ($6M/{1 - 0.4})] = [$35M] / [$15M +($6M/0.6)] = $35M/$25M = 1.4.

[NOTE. The amount of principal repayments is divided by 1 minus the tax rate, because principal repayments are not tax deductible.]

(A6) Explain why selecting a target senior debt rating is a reasonable approach to choosing a capital structure. Explain why a target senior debt rating of single-A is a prudent objective when there is only a very limited new issue market for non-investment grade debt and when investor willingness to purchase triple-B-rated debt is likely to be highly sensitive to the state of the economy.

Selecting a target senior debt rating is a reasonable approach to choosing a capital structure because the debt rating encompasses three of the five principal considerations that affect the capital structure decision. The debt rating accounts for the firm's ability to service its debt, the degree of protection afforded by the liquidity of the firm's assets, and largely determines the firm's ease of access to the capital markets. A target senior debt rating of single-A is a prudent objective because it is the lowest rating that historically has allowed the issuer to maintain uninterrupted access to the capital markets.

(a) What form would an exchange offer take if the firm believes it is overleveraged?

If a firm's capital structure is different from its target capital structure, the firm can bring its capital structure in line with its target by adjusting its future financing mix appropriately. The firm can change its capital structure quickly by making an exchange offer, recapitalization offer, debt or share repurchase, or stock-for-debt swap.

If the firm believes it is overleveraged, it would want to decrease its leverage with a stock-for-debt exchange.

(b) What form would an exchange offer take if the firm believes it is underleveraged?

If the firm believes it is underleveraged, it would want to increase its leverage with a debt-for-stock exchange.

(A10) Suppose a firm is unleveraged and has an unleveraged required return, r, of 15%. The firm borrows 30% of the value of the firm at r_d = 8%. Because of the financial leverage, r_e becomes 18%. What is the firm's WACC under each of the below conditions.

The firm borrows 30% of the value of the firm means that L = D/V_L = 0.3. Under perfect capital markets where T = 0, we have: WACC = (1-L)r_e + L(1-T)r_d = (1-0.3)18% + 0.3(1-0)8% = 12.6% + 2.4% = 15%.

(b) There are only corporate taxes at a rate of 35% in an otherwise perfect capital market.

With corporate taxes where T = 0.35, we have: WACC = (1-L)r_e + L(1-0.35)r_d = (1-0.3)18% + 0.3(1-0.35)8% = 12.6% + 1.56% = 14.16%.

(A11) Nathan's Catering is a gourmet catering service located in Southampton, New York. It has an unleveraged required return of r = 43%. Nathan's rebalances its leverage each year to a target of L = 0.52 and T* = 0.20. Nathan can borrow currently at a rate of r_d = 26%. What is Nathan's WACC?

We have: WACC = r - [T*Lr_d(1+r)/(1+r_d)] = 0.43 - [0.2(0.52)0.26(1.43)/(1.26)] = 0.43 - 0.306882 = 0.3993117 or about 39.93%.

(B3) Sanderson Manufacturing Company would like to achieve a capital structure consistent with a Baa2/BBB senior debt rating. Sanderson has identified six comparable firms and calculated the following credit statistics:

Sr debt Baa2/ Baa3/ Baa2/ Baa1/ Baa1/ Baa2/
rating BBB BBB- BBB A- BBB- BBB+

(a) Sanderson's return on assets is 5.3%. It has a total capitalization of $600M. What are reasonable targets for long-term debt/capitalization, cash flow/long-term debt, and fixed-charge coverage?

Long-term debt/capitalization target: 40% to 45% (we don't use 38% because the asset size is too small for that comparison).

Fixed charge coverage target: 2.50 to 2.75 (corresponds with those two firms that have Baa2/BBB ratings.

(b) Are there any firms among the six who are particularly good or bad comparables? Explain.

Firms A, C, and F have senior debt ratings consistent with Sanderson's target so they are good comparables. Of these three, firm C has total capitalization closest to that of Sanderson's. Firm E is a particularly poor comparable due to the significant size difference.

(c) Suppose Sanderson's current ratio of long-term debt to total capitalization is 60% but its fixed-charge coverage is 3.00. What would you recommend?

The relatively high ratio of long-term debt to total capitalization and relatively high fixed charge coverage ratio offset each other to some degree. Nevertheless, Sanderson should plan on reducing its long-term debt ratio to the target range within at most a few years.

(B8) Suppose Quaker Oats Corp. is evaluating a potential new investment. The investment will be financed with $100,000 of debt and $100,000 of equity. The (unleveraged) after-tax cash flows, the CFATs, expected to result from the investment are $150,000 per year for 4 years. At that time Quaker Oats expects to be able to sell the project for a net after-tax $100,000 in cash. The debt financing will be 4-year debt with interest payments of 14% per year on the remaining balance. Principal payments will be zero in year 1, $20,000 in year 2, $30,000 in year 3, and a final principal payment of $50,000 at the end of year 4. The net-benefit-to-leverage factor, T*, is 0.20. The (unleveraged) required return for the project is 20%. What is the project's net APV?

We first need a loan amortization schedule to identify the interest payments over the life of the loan. This is given below.

Year                                     1st              2nd           3rd             4th
Balance, start of year    100,000      100,000      80,000       50,000
Interest                            14,000        14,000       11,200        7,000
Payment                             0              20,000       30,000      50,000
Ending Principal          100,000        80,000       50,000            0

The net adjusted present value of the project is the adjusted present value (APV₀) minus the initial costs (CF₀) where APV₀ = CFAT₁/(1+r)¹ + T*INT₁/(1+r_d)¹ + CFAT₂/(1+r)² + T*INT₂/(1+r_d)² + ... + CFAT_n/(1+r)ⁿ + T*INT_n/(1+r_d)ⁿ. Noting that we can use our present value annuity factor for some cash flows streams and inserting our values, we have: PV₀ = $150,000{1 - [1/(1.2)⁴]/0.2} + $100,000/(1.2)⁴ + 0.2[$14,000/1.14 + $14,000/(1.14)² + $11,200/(1.14)³ + $7,000/(1.14)⁴] = $150,000{2.5887346} + $48,225.309 + 0.2[$12,280.702 + $10,772.545 + $7,559.681 + $4,144.5619] = $388,310.19 + $48,225.309 + 0.2[$34,757.49] = $436,535.49 + $6,951.498 = $443,486.50.

(B11) The RTE Corporation expects to pay a dividend next year of $2.22. It expects its cash dividends to grow 5% per year forever. RTE has a debt ratio of L = 35%. Its borrowing rate is r_d = 9%. RTE pays corporate taxes at the rate of 30%, r_f = 6%, r_M = 12%, and RTE's common stock is currently selling for $20 per share.

(a) What is the current (leveraged) required return, r_e, on RTE's common stock?

We apply the dividend growth model and solve for r_e. We have: r_e = D₁/P₀ + g = $2.22/$20 + 0.05 = 0.161 or about 16.1%.

(b) What is RTE's WACC? (HINT: WACC = r(1-T*L) where T* is the net-benefit-to-leverage factor given in Chapter 15, Section 9.)

RTE's after-tax weighted average cost of capital is: WACC = (1-L)r_e + L(1-T)r_d = (1-0.35)(16.1%) + 0.35(1-0.3)9% = 10.465% + 2.205% = 12.67%.

Using the above equation with T* = T, then the equation WACC = r(1-T*L) = r(1-TL) implies r = WACC/[1 - (TL)] = 12.67%/[1 - (0.3)(0.35)] = 0.14156425 or about 14.16%.

The unleveraged beta implied by r = 14.16% can be found by using the CAPM where r = r_f + (r_M - r_f). Solving for , we have = (r - r_f) / (r_M - r_f) = (0.1416 - 0.06) / (0.12 - 0.06) = 1.36.

(e) What would you way about the estimates in parts a through d if you learned that the market model estimated a (leveraged) beta of 2.2 for RTE's common stock?

A leveraged beta of 2.2 implies a leveraged required return on RTE's common stock of r_e = r_f + (r_M - r_f) = 6% + 2.2(12% - 6%) = 19.2%.

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