Capital Structure Planning. Why Financial Restructuring?

Transcription

1 Giddy/SIM Capital Structure /1 SIM/NYU The Job of the CFO Capital Structure Planning Prof. Ian Giddy New York University Why Financial Restructuring? The Asian Bet The Solution, Part I: Recapitalization The Solution, Part II: Financial Restructuring The Solution, Part III: Corporate Restructuring Capital Structure 3

2 Giddy/SIM Capital Structure /2 The Asian Bet High growth disguised speculative financing structures Governments shielded companies and banks from capital market discipline Too much debt Too much foreign-currency debt Closely held ownership relying on reinvested earnings Capital Structure 4 The Asian Bet High growth disguised speculative financing structures Governments The three shielded excesses companies and banks from Too capital much market debt discipline Too much Too debtmuch labor Too much Too foreign-currency much capacity debt Closely held ownership relying on reinvested earnings Capital Structure 5 Example: Hyundai Group

3 Giddy/SIM Capital Structure /3 How the Bet was Lost Vulnerable economies, newly liberalized, succumbed to currency crises Economic downturns followed Companies were unable to service even domestic debt, never mind foreign currency debt Still unreformed, many Asian companies remain misfinanced Capital Structure 6 Example: Hyundai Group What is Corporate Restructuring? Any substantial change in a company s financial structure, or ownership or control, or business portfolio. Designed to increase the value of the firm Restructuring Improve capitalization Improve debt composition Change ownership and control Capital Structure 7

4 Giddy/SIM Capital Structure /4 It s All About Value How can corporate and financial restructuring create value? Assets Liabilities Fix the business Operating Cash Flows Debt Equity Or fix the financing Capital Structure 8 Restructuring Figure out what the business is worth now Fix the business mix divestitures Fix the business strategic partner or merger Fix the financing improve D/E structure Fix the kind of equity Fix the kind of debt or hybrid financing Fix management or control Use valuation model present value of free cash flows Value assets to be sold Value the merged firm with synergies Revalue firm under different leverage assumptions lowest WACC What can be done to make the equity more valuable to investors? What mix of debt is best suited to this business? Value the changes new control would produce Capital Structure 9

5 Giddy/SIM Capital Structure /5 Getting the Financing Right Step 1: The Proportion of Equity & Debt Debt Equity Achieve lowest weighted average cost of capital May also affect the business side Capital Structure 10 Getting the Financing Right Step 2: The Kind of Equity & Debt Debt Equity Short Short term? term? Long Long term? term? Baht? Baht? Dollar? Dollar? Yen? Yen? Bonds? Bonds? Asset-backed? Asset-backed? Convertibles? Convertibles? Hybrids? Hybrids? Debt/Equity Debt/Equity Swaps? Swaps? Private? Private? Public? Public? Strategic Strategic partner? partner? Domestic? Domestic? ADRs? ADRs? Ownership Ownership & control? control? Capital Structure 11

6 Giddy/SIM Capital Structure /6 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 the real business just by shuffling paper - Modigliani-Miller Capital Structure 12 Does Capital Structure Matter? Yes! 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 COST OF CAPITAL Optimal debt ratio? DEBT RATIO Capital Structure 13

7 Giddy/SIM Capital Structure /7 Does Capital Structure Matter? Yes! 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 VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO Capital Structure 14 Does Capital Structure Matter? Yes! 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 Value of Firm = PV(Cash Flows) + PV(Tax Shield) - Distress Costs Capital Structure 15

8 Giddy/SIM Capital Structure /8 Managing the capital base Optimizing the mix of capital, e.g., raised US$500 million Tier 2 capital in April 2000 Flexibility to redeem non-voting shares and buy back ordinary shares Flexibility to dispose remaining non-core assets Utilizing excess capital for organic growth and acquisitions Capital Structure 16 Changing Financial Mix Debt is always cheaper than equity, partly because lenders bear less risk and partly because of the tax advantage associated with debt. 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). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more debt. Capital Structure 17

9 Giddy/SIM Capital Structure /9 Debt: Pros and Cons Advantages of Borrowing 1. Tax Benefit: Higher tax rates --> Higher tax benefit 2. Added Discipline: Greater the separation between managers and stockholders --> Greater the benefit Disadvantages of Borrowing 1. Bankruptcy Cost: Higher business risk --> Higher Cost 2. Agency Cost: Greater the separation between stockholders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost Capital Structure 18 See Saw Business Uncertainty Operating Leverage Financial Risk Financial Leverage Capital Structure 19

10 Giddy/SIM Capital Structure /10 Young and Old Size Financial Leverage Operating Leverage Operating Leverage Financial Leverage Maturity Capital Structure 20 Disney Weighted Average Cost of Capital and Debt Ratios WACC 11.40% 11.20% 11.00% 10.80% 10.60% 10.40% 10.20% 10.00% 9.80% 9.60% 9.40% 0 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Debt Ratio Capital Structure 21

11 Giddy/SIM Capital Structure /11 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% % AAA 11.55% 33.45% 7.69% 16.95% $1,046 10% % AA 11.95% 33.45% 7.95% 16.78% $1,064 20% % A % 33.45% 8.49% 16.71% $1,071 30% % B % 33.45% 9.48% 16.90% $1,052 40% % B % 33.45% 10.81% 17.41% $1,001 50% % CCC 17.25% 33.45% 11.48% 17.86% $961 60% % CC 18.75% 25.67% 13.94% 20.02% $803 70% % C 20.25% 20.38% 16.12% 22.47% $674 80% % C 20.25% 17.83% 16.64% 23.90% $615 90% % C 20.25% 15.85% 17.04% 25.32% $565 Cost of Capital 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 0% 20% 40% 60% 80% 100% Debt Percentage Value ($millions) % 20% 40% 60% 80% 100% Debt Percentage Capital Structure 22 Capital Structure: East vs West Intel TPI VALUE OFTHE FIRM Optimal debt ratio? DEBT RATIO Capital Structure 23

12 Giddy/SIM Capital Structure /12 Case Study: Sammi Sammi Steel 1989 Acquisition of Atlas Capital Structure 24 Perceived Benefits to Sammi From Acquisition of Atlas Steel Achieve $280mm savings by acquiring Atlas Steel and related companies Cost of setting up own production facility would have been $500 mm Savings were channeled into restructuring production facilities at existing plants Sammi s share price rose 9% on news of strategic acquisitions Capital Structure 25

13 Giddy/SIM Capital Structure /13 How Should the Acquisition Have Been Financed? Assets added: $210 million Debt added: $210 million (C$250m) Capital Structure 26 How Should the Acquisition Have Been Financed? Assets added: $210 million Debt added: $210 million (C$250m) Loan: C$180m Ret Ret earn: C$70m Plus w.cap.: Eurobond with warrants US$50m Capital Structure 27

14 Giddy/SIM Capital Structure /14 Problems faced by Sammi from the Acquisition Post acquisition debt-equity ratio soared from below 1:1 to 2:1, above industry averages Future refinancing of debt caused earnings after interest costs to fall 17% Purchase price of $210.6 mm found to have been excessive The acquisition was ill-timed Existing and new plants suffered from low capacity utilization of around 65% Capital Structure 28 Sammi Steel in 1995 Sammi Atlas pushed to raise productivity by 15% A leaner organization: Work force had shrunk by 19.4% since year freezes on salaries to limit labor costs Unrelated and unprofitable businesses have been sold off New export zones identified in China and South- East Asia Conversion of debt into equity to reduce interest costs by 6%; Result: dilution in EPS, unless offset by increased volume of sales Capital Structure 29

15 Giddy/SIM Capital Structure /15 Analysis of Change in Value of Sammi Steel ( Billions of Korean Won) Sales Operating Profit % of Sales 6.00% 7.00% Net Profit as a % of Sales 2.30% -9.60% Debt / Equity Ratio Market Value of 1 Share KOSPI Capital Structure 30 March 1997 Sammi Steel is bankrupt! ALTO Capital Structure 31

16 Giddy/SIM Capital Structure /16 March 1997 Sammi Steel is bankrupt! Dr F R Structuring Diagnosis Prevention ALTO and Cure Capital Structure 32 Financing Choices Assets value is the present value of the cash flows from the real business of the firm 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 Capital Structure 33

17 Giddy/SIM Capital Structure /17 Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO MEASUREMENT CAPITAL DEBT EQUITY M&ACase Study: Intralinks TOOLS Capital Structure 34 Financing Growth Companies Prof. Ian Giddy New York University

18 Giddy/SIM Capital Structure /18 Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT PORTFOLIO CAPITAL M&A DEBT EQUITY MEASUREMENT TOOLS Capital Structure 36 The CFO Questions How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? How should we finance our growth? What kind of equity? What s our exit plan? Private or public? How much (cheap) debt should we have? What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? How should we manage our financial risks? Capital Structure 37

19 Giddy/SIM Capital Structure /19 Financing X Inc Capital Structure 38 Financing X Inc Capital Structure 39

20 Giddy/SIM Capital Structure /20 Financing X Inc Capital Structure 40 Corporate Financing Life-Cycle Leverage Growth companies Mature companies Capital Structure 41

21 Giddy/SIM Capital Structure /21 Firm Characteristics as Growth Changes Variable High Growth Firms tend to Stable Growth Firms tend to Risk be above-average risk be average risk Dividend Payout pay little or no dividends pay high dividends Net Cap Ex have high net cap ex have low net cap ex Return on Capital earn high ROC (excess return) earn ROC closer to WACC Leverage have little or no debt higher leverage Earnings 0 Gearing (Leverage) Capital Structure 42 Financing Growth Companies: The Agenda Where can we get the initial equity financing we need to grow? Do we want money, management, or more? When do we want to sell out, and how? When is the right time for debt for a growth company? What kind? Capital Structure 43

22 Giddy/SIM Capital Structure /22 What Kind of Equity? Sources of Equity Private investors Strategic investors Interventionist investors Public market And Kinds Common stock Stock with restricted voting rights Hybrids, including convertibles Capital Structure 44.comfax (now Messageclick) Started in September 1997,.comfax enables users to send faxes and receive faxes over the internet at a low cost. By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day. 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. What form of equity financing would be appropriate for.comfax? Capital Structure 45

23 Giddy/SIM Capital Structure /23 Pre-IPO Equity Financing Friends and family Angel Venture capital Strategic partners Capital Structure 46 Pre-IPO Equity Financing Friends and family Angel Venture capital Strategic partners asiajack.com Capital Structure 47

24 Giddy/SIM Capital Structure /24 Private Equity Funds Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring. The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors. Capital Structure 48 Silipos Inc Capital Structure 49

25 Giddy/SIM Capital Structure /25 Silipos Inc, 1999 Debt? Where do you want to go? IPO? Acquisition? Sell? Capital Structure 50 IntraLinks Capital Structure 51

26 Giddy/SIM Capital Structure /26 IntraLinks Choices 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. Seek out one or more private equity investors, ones who believed in the company s product and its management. Do an initial public offering (IPO). Find another corporation who would be willing to acquire IntraLinks. Capital Structure 52 Why Venture Capitalists Prefer Preferred Senior status in bankruptcy Does not put a value on the shares Is convertible into common stock before the IPO Conversion price is set such that if there is a liquidation all the money goes to the preferred shareholders (equity is worth zero) Capital Structure 53

27 Giddy/SIM Capital Structure /27 Case Study: Photronics Capital Structure 54 Case Study: Photronics Photronics is the world's leading and fastest growing manufacturer of photomasks. Photomasks are high precision quartz plates that contain microscopic images of electronic circuits. A key element and enabling technology in the manufacture of semiconductors, photomasks are used to transfer circuit patterns onto semiconductor wafers during the fabrication of integrated circuits. They are produced in accordance with circuit designs provided by customers at strategically located manufacturing facilities in North America, Europe and Asia. Capital Structure 55

28 Giddy/SIM Capital Structure /28 Case Study: Photronics Sales, Balance Sheet, end-1999 USD millions Assets Liabilities & Equity Cash 7.6 Current liabilities 50.2 Other current assets 59.9 Long term liabilities Long term assets Shareholder's equity Total Total Market capitalization 720 P/E 26x EBIT/Int cost 5.77 Book Market D/E D/(D+E) Capital Structure 56 The Company s Debt Capital Structure 57

29 Giddy/SIM Capital Structure /29 Should Photronics Have More Debt? Benefits of Debt Tax Benefits Adds discipline to management Costs of Debt Bankruptcy Costs Agency Costs Loss of Future Flexibility Capital Structure 58 The CFO Questions How fast can we grow? What criteria for spending money? Acquisitions? Divestitures? How should we finance our growth? What kind of equity? What s our exit plan? Private or public? How much (cheap) debt should we have? What kind of debt should we have? Maturity? Fixed/floating? Currency? Asset-backed? Hybrids, such as convertibles? How should we manage our financial risks? Capital Structure 59

30 Giddy/SIM Capital Structure /30 Some Useful Websites giddy.org/jcfo.htm giddy.org giddyonline.com shareinvestor.com dialpad.com onebox.com Capital Structure 60 Measuring the Cost of Capital Cost of funding equal return that investors expect Expected returns depend on the risks investors face (risk must be taken in context) Cost of capital Cost of equity Cost of debt Weighted average (WACC) Capital Structure 61

31 Giddy/SIM Capital Structure /31 A $1 Investment in Different Types of Portfolios: Index ($) Small Company Stocks Large Company Stocks Long-Term Government Bonds $4, $1, $33.73 $13.54 $ Treasury Bills Year-End 0.1 Inflation Capital Structure 62 DISCOUNTED CASHFLOW VALUATION Cashflow to Firm EBIT (1-t) - (Cap Ex - Depr) - Change in WC = FCFF Expected Growth Reinvestment Rate * Return on Capital Firm is in stable growth: Grows at constant rate forever Value of Operating Assets + Cash & Non-op Assets = Value of Firm - Value of Debt = Value of Equity Terminal Value= FCFFn+1/(r-gn) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn... Forever Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equ Cost of Equity Cost of Debt (Riskfree Rate + Default Spread) (1-t) Weights Based on Market Value Riskfree Rate : - No default risk - No reinvestment risk - In same currency and in same terms (real or nominal as cash flows + Beta Risk Premium - Measures market risk X - Premium for average risk investment Type of Business Operating Leverage Financial Leverage Base Equity Premium Country Risk Premium Capital Structure 66

32 Giddy/SIM Capital Structure /32 Let s Start With the Cost of Debt The cost of debt is the market interest rate that the firm has to pay on its borrowing. It will depend upon three components- (a) The general level of interest rates (b) The default premium (c) The firm's tax rate Capital Structure 67 Interest Coverage Ratios, Ratings and Default Spreads If Interest Coverage Ratio is Estimated Bond Rating Default Spread > 8.50 AAA 0.20% AA 0.50% A+ 0.80% A 1.00% A 1.25% BBB 1.50% BB 2.00% B+ 2.50% B 3.25% B 4.25% CCC 5.00% CC 6.00% C 7.50% < 0.20 D 10.00% Capital Structure 71

33 Giddy/SIM Capital Structure /33 Other Factors Affecting Ratios Medians of Key Ratios : Pretax Interest Coverage EBITDA Interest Coverage Funds from Operations / Total Debt (%) Free Operating Cashflow/ Total Debt (%) Pretax Return on Permanent Capital (%) Operating Income/Sales (%) Long Term Debt/ Capital Total Debt/Capitalization AAA AA A BBB BB B CCC % 69.1% 45.5% 33.3% 17.7% 11.2% 6.7% 60.0% 26.8% 20.9% 7.2% 1.4% 1.2% 0.96% 29.3% 21.4% 19.1% 13.9% 12.0% 7.6% 5.2% 22.6% 17.8% 15.7% 13.5% 13.5% 12.5% 12.2% 13.3% 21.1% 31.6% 42.7% 55.6% 62.2% 69.5% 25.9% 33.6% 39.7% 47.8% 59.4% 67.4% 69.1% Capital Structure 72 Estimating Siderar s Cost of Debt (in $) Riskfree Rate = 6% Country default spread = 5.25% (Argentine default spread) I am assuming that all Argentine companies have to pay at least this spread. Rating for Siderar = A- Default spread = 1.25% Pre-tax cost of borrowing for first 5 years= 6% % % = 12.50% Capital Structure 73

34 Giddy/SIM Capital Structure /34 The Cost of Equity Equity is not free! Expected return = Risk-free rate + Risk Premium E(R Risky ) = R Risk-free -+ Risk Premium Capital Structure 74 The Cost of Equity Consider the standard approach to estimating cost of equity: Cost of Equity = R f + Equity Beta * (E(R m ) - R f ) where, R f = Riskfree rate E(R m ) = Expected Return on the Market Index (Diversified Portfolio) In practice, Short term government security rates are used as risk free rates Historical risk premiums are used for the risk premium Betas are estimated by regressing stock returns against market returns Capital Structure 75

35 Giddy/SIM Capital Structure /35 Valuing a Firm from Different Risk Perspectives Firm is assumed to have a cash flow of 100 each year forever. Investor Type Cares about Risk Measure Cost of Project Risk Equity Private Business: Owner has Competitive Risk Total Standard all his wealth invested in the Sector Risk Risk Deviation 40% business Int nl Risk Market Risk Firm Value 100/.4=250 Project Risk Venture Capitalist: Has wealth invested in a number of companies in one sector Competitive Risk Sector Risk Int nl Risk Market Risk Risk added to sector portfolio Beta relative to sector 25% 100/.25=400 Publicly traded company with investors who are diversified domestically or IPO to investors who are domestically diversified Project Risk Competitive Risk Sector Risk Int nl Risk Market Risk Risk added to domestic portfolio Beta relative to local index 15% 100/.15=667 Publicly traded company with investors who are diverisified globally or IPO to global investors Project Risk Competitive Risk Sector Risk Int nl Risk Market Risk Risk added to global portfolio Beta relative to global index 10% 100/.10=1000 Capital Structure 76 The Cost of Capital Choice Cost 1. 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 and Capital cost of debt; weights based upon market value. Cost of capital = k d [D/(D+E)] + k e [E/(D+E)] Capital Structure 80

36 Giddy/SIM Capital Structure /36 Estimating Cost of Capital: Siderar Equity Cost of Equity = 6.00% (16.03%) = 17.38% Market Value of Equity = 3.20* = 995 million (94.37%) Debt Cost of debt = 6.00% % % (default spread) = 12.5% Market Value of Debt = 59 Mil (5.63%) Cost of Capital Cost of Capital = 17.38%(.9437) %( )(.0563)) = 17.38%(.9437) %(.0563) = 16.87% Capital Structure 81 Next, Minimize the Cost of Capital by Changing the Financial Mix The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm. Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt. 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). The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt. Capital Structure 82

37 Giddy/SIM Capital Structure /37 This is What We re Trying to Do D/(D+E) ke kd After-tax Cost of Debt WACC % 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% Capital Structure 83 Cost of Capital and Leverage: Method Equity Estimated Beta With current leverage From regression Unlevered Beta With no leverage Bu=Bl/(1+D/E(1-T)) Levered Beta With different leverage Bl=Bu(1+D/E(1-T)) Cost of equity With different leverage E(R)=Rf+Bl(Rm-Rf) Debt Leverage, EBITDA And interest cost Interest Coverage EBITDA/Interest Rating (other factors too!) Cost of debt With different leverage Rate=Rf+Spread+? Capital Structure 84

38 Giddy/SIM Capital Structure /38 Siderar: Optimal Debt Ratio Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G) 0% % AAA 11.55% 33.45% 7.69% 16.95% $1,046 10% % AA 11.95% 33.45% 7.95% 16.78% $1,064 20% % A % 33.45% 8.49% 16.71% $1,071 30% % B % 33.45% 9.48% 16.90% $1,052 40% % B % 33.45% 10.81% 17.41% $1,001 50% % CCC 17.25% 33.45% 11.48% 17.86% $961 60% % CC 18.75% 25.67% 13.94% 20.02% $803 70% % C 20.25% 20.38% 16.12% 22.47% $674 80% % C 20.25% 17.83% 16.64% 23.90% $615 90% % C 20.25% 15.85% 17.04% 25.32% $565 Question: If Siderar s current debt ratio is 60%, what do you recommend? Capital Structure 85 Siderar: Optimal Debt Ratio Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G) 0% % AAA 11.55% 33.45% 7.69% 16.95% $1,046 10% % AA 11.95% 33.45% 7.95% 16.78% $1,064 20% % A % 33.45% 8.49% 16.71% $1,071 30% % B % 33.45% 9.48% 16.90% $1,052 40% % B % 33.45% 10.81% 17.41% $1,001 50% % CCC 17.25% 33.45% 11.48% 17.86% $961 60% % CC 18.75% 25.67% 13.94% 20.02% $803 70% % C 20.25% 20.38% 16.12% 22.47% $674 80% % C 20.25% 17.83% 16.64% 23.90% $615 90% % C 20.25% 15.85% 17.04% 25.32% $565 Cost of Capital 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% 0% 20% 40% 60% 80% 100% Debt Percentage Value ($millions) % 20% 40% 60% 80% 100% Debt Percentage Capital Structure 86

39 Giddy/SIM Capital Structure /39 A Framework for Getting to the Optimal Is the actual debt ratio greater than or lesser than the optimal debt ratio? Actual > Optimal Overlevered Actual < Optimal Underlevered Is the firm under bankruptcy threat? Is the firm a takeover target? Yes No Yes No Reduce Debt quickly 1. Equity for Debt swap 2. Sell Assets; use cash to pay off debt 3. Renegotiate with lenders Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Increase leverage quickly 1. Debt/Equity swaps 2. Borrow money& buy shares. Does the firm have good projects? ROE > Cost of Equity ROC > Cost of Capital Yes Take good projects with new equity or with retained earnings. No 1. Pay off debt with retained earnings. 2. Reduce or eliminate dividends. 3. Issue new equity and pay off debt. Yes Take good projects with debt. No Do your stockholders like dividends? Yes Pay Dividends No Buy back stock Capital Structure 87 giddy.org Ian Giddy NYU Stern School of Business Tel Fax ian.giddy@nyu.edu Capital Structure 92