CAPITAL STRUCTURE BAFI502 PERIOD 2 2011 Instructor: Teaching Assistant: Kai Li Alejandra Medina DL-530 Alejandra.Medina@sauder.ubc.ca kai.li@sauder.ubc.ca Office Hours: Monday/Wednesday 13:00-14:00 Office Hours: by appointment Office: Syllabus Course Objective: This course focuses on the considerations that enter the capital structure and payout policy choices of a firm. A review of the basic principles of capital structure and payout policy is provided followed by a detailed discussion of specific considerations. The topics covered include the impact of taxes and bankruptcy costs on the use of debt, financial restructuring in distressed companies, the disciplinary role of high leverage, the interaction between capital structure and business strategy, payout policy (dividends versus share repurchases), and the role of market imperfections in emerging market financing decisions. The course concludes with an overview of latest topics in capital structure decisions. Business cases and real world applications are used extensively throughout the course. This course will be useful to students considering careers in corporate finance, investment banking, commercial banking and consulting. Teaching methods: I will present the basic insights of corporate finance theory, but emphasize the application of theory to real business decisions. Each session will involve class discussion. In some instances, discussion will be centered on lectures; in others it will be centered on a business case. Your participation is critical to the success of the course. You are expected to read all cases, come to class, and participate in class discussion. I welcome comments from you to improve the course. Prerequisites: BAFI500 Corporate Finance and BAFI511 Investments. It will also help if you know some basic economics and accounting. Readings/Books: Higgins, Analysis for Financial Management, 2009, 9 th ed., Irvin, McGraw-Hill. Berk, DeMarzo, Stangeland, Corporate Finance, 2010, Canadian Edition, ISBN No. 978-0-321-62599-1, Pearson Canada (recommended). Brealey, Myers, and Allen, Principles of Corporate Finance, 10 th Edition (recommended). HBS cases can be purchased at the following HBS website: http://cb.hbsp.harvard.edu/cb/access/5637777. Case exhibits and additional reading material are posted on Blackboard Vista. Requirements/Grading: Case Write-ups: 40% - Students should form teams of 4 to 5, and hand in a single write-up per team. - Both hardcopy and email-version of the write-ups are due on the day that the case is discussed in the beginning of the class (make copies to refer to during the class). Please hand in the hardcopies in class, and email the same write-ups to Alejandra.Medina@sauder.ubc.ca. - All cases require handing in write-ups. 1
- Grading guidelines are at the end of this syllabus Class Participation: 10% Final Exam: 50% Team formation: Teams will be 4-5 students each. Teams with members less than four and greater than five are strongly discouraged. Further details: Each group is required to submit ONE two-page memorandum on the cases. The memorandums should be typed. They should be written as if your were presenting it to your business colleagues. The two-page limit is for text only. Please use font 11 or 12. If we cannot read, we cannot grade. You may attach as many numerical calculations as you wish. Memorandums will not be accepted after the class has met. Class attendance and participation in case discussions is critical to the learning process. My teaching assistant is Alejandra Medina. Her main responsibility will be grading case write-ups and answering questions during office hours. Course outline (in brief): subject to adjustments Changes to this calendar will be available on the course webpage. # Date Topic Assignment (date due) 1 Tu, Feb 22 Lecture: Introduction 2 Th, Feb 24 Case: Cartwright Lumber Company Cartwright Lumber Lecture: Capital Structure I part A 3 Tu, Mar 1 Lecture: Capital Structure I part B 4 Th, Mar 3 Case: UAL, 2004: Pulling Out of Bankruptcy UAL Lecture: Capital Structure II part A 5 Tu, Mar 8 Lecture: Capital Structure II part B 6 Th, Mar 10 Case: Sealed Air Corporation s Leveraged Recapitalization Sealed Air Guest Speakers: 7 Tu, Mar 15 Case: Dividend Policy at Linear Technology Linear Technology 8 Th, Mar 17 Guest Speaker: 9 Tu, Mar 22 Lecture: Frontier Topics in Capital Structure 10 Th, Mar 24 Case: Geeli Geeli 2
Course Outline Objective: The aim of the course is to develop a framework to think about how firms finance their activities. We will go back and forth between developing theories and confronting them to specific practical cases. 1 Introduction Background readings: - BMA, ch. 15: An Overview of Corporate Financing - Higgins, ch. 1: Interpreting Financial Statements - Higgins, ch. 2: Evaluating Financial Performance 2 Case Study: Cartwright Lumber Company 1. Why does Mr. Cartwright have to borrow so much money to support this profitable business? 2. Do you agree with his estimate of the company s loan requirements? How much will he need to borrow to finance his expected expansion in sales (assume a 2004 sales volume of $3.6 million)? 3. As Mr. Cartwright s financial adviser, would you urge him to go ahead with, or to reconsider, his anticipated expansion and his plans for additional debt financing? As the banker, would you approve Mr. Cartwright s loan request, and, if so, what conditions would you put on the loan? Readings: - BMA, ch. 29: Financial Analysis and Planning - Higgins, ch. 3: Financial Forecasting - Higgins, ch. 4: Managing Growth 3 Lecture: Capital Structure I Readings: - BMA, ch. 18: Does Debt Policy Matter? - BMA, ch. 19: How Much Should a Firm Borrow? - Graham, Estimating the Tax Benefits of Debt - Higgins, ch. 5: Financial Instruments and Markets - BMA, ch. 16: How Corporations Issue Securities - Higgins, ch. 6: The Financing Decision 4 Case Study: UAL, 2004 1. Why did UAL file for bankruptcy protection in December 2002? 3
2. What is the rationale for allowing companies to restructure their debts and operations under Chapter 11 bankruptcy protection? a. What is the role of the automatic stay, which prevents creditors from pursuing their claims to a defaulted borrower s assets outside of bankruptcy court? b. Why do we allow debtor-in-possession financing for companies operating under Chapter 11 protection? Why are DIP loans granted seniority to firms pre-petition obligations? 3. What are the incentives of the different parties involved in restructuring UAL? What are the incentives of the firm s management? Secured creditors? DIP lenders? Unsecured creditors? Employees? 4. What are the important costs of financial distress that UAL is facing? How would these costs of financial distress vary across different industries? 5. Why has leverage in the airline industry been high relative to other industries? 6. As UAL, would you continue making required contributions to your pension plans? 7. As UAL, would you cancel your commitments to your pension plans? - BMA, ch. 24: Credit Risk and The Value of Corporate Debt - BMA, ch. 26: Leasing - BMA, ch. 33: Corporate Restructuring 5 Lecture: Capital Structure II: Informational and Agency Considerations Reading: - Barclay, Smith, The Capital Structure Puzzle: The Evidence Revisited - Shivdasani, Zenner, How To Choose a Capital Structure? - Datta, Iskandar-Datta, Patel, Do Bank Relationships Matter in Public Debt Offerings? 6 Case Study: Sealed Air Corporation 1. Why did Sealed Air undertake a leveraged recapitalization? 2. How much value was created? Where did it come from? 3. Is pursuing a program of manufacturing excellence inconsistent with levering up? 4. Why did Dermot Dunphy, the CEO, feel it was necessary to change the company s priorities and incentive structure following the recap? 5. Was the constraint imposed on capital expenditures under the bank lending agreement good or bad for the company? Do you think managers will be able to successfully renegotiate this covenant if needed? 4
6. Do you think leveraged recapitalizations are a good idea? For whom? (type of investor, type of firm) 7 Case Study: Dividend Policy at Linear Technology 1. Describe Linear Technologies payout policy. 2. What are Linear s financing needs? Should Linear return cash to its shareholders? What are the tax consequences of keeping cash inside the firm? 3. If Linear were to pay out its entire cash balance as a special dividend, what would be the effect on value? On the share price? On earnings? On earnings per share? What if Linear repurchased shares instead? Assume a 3% rate of interest. 4. Why do firms pay dividends? Why has the rate of dividend initiations changed over time? 5. What should Paul Coghlan recommend to the board? - BMA, ch. 17: Payout Policy - Dittmar, Corporate Cash Policy and How to Manage It with Stock Repurchases - Fama, French, Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay? - Julio, Ikenberry, Reappearing Dividends - Grullon, Ikenberry, What Do We Know About Stock Repurchases? - Pinkowitz, Williamson, Stulz, Cash Holdings, Dividend Policy, and Corporate Governance: A Cross-Country Analysis 8 Lecture: Frontier Topics in Capital Structure Background readings: - BMA, ch. 34: Governance and Corporate Control Around the World - Kisgen, The Influence of Credit Ratings on Corporate Capital Structure Decisions - Broshko, Li, Playing by the Rules - Harford, Li, Zhao, Corporate Boards and the Leverage and Debt Maturity Choices - Hall, The Six Challenges of Equity-Based Pay Design 9 Case Study: Geeli 1. From the perspective of U.S. investors, what are the opportunities and challenges of investing in an emerging market economy like China? 2. As a U.S. investor contemplating investing in Geeli, how would you value the expansion plan? Assume that the market risk premium is 5%. 3. What are the alternative ways for Geeli to raise the required funding, should they decide to proceed with the expansion plan? What are the benefits and costs of using each one of the alternatives? 5
4. How might Geeli s financing strategy differ if it were operating in the U.S.? How do market imperfections affect its financing choices and capital structure? - HBS Note on Depositary Receipts 6
Guidance on Grading Think of yourself as an analyst preparing a memorandum for a senior partner, MD, or associate of a firm. A (85): For a memorandum / writeup that a senior banker/analyst would be happy to take to a client meeting as is, that completely answers the question or questions posed, contains no noticeable errors, and is nicely presented. A (80): For a writeup that covers most of the relevant question and/or has minor errors, and could be presented to a client with only minor modifications. B+ (76): May miss some relevant areas or have some minor mistakes, but these could be fixed with a brief email or short discussion. B and lower (75 and below): If a lengthier conversation would be required to correct mistakes or omissions in the writeup, and to probe what areas the analyst needed reinforcement in to improve the quality of the memorandum A+ (90 and above): If the writeup is so impressive that the senior banker would want to bring the analyst to the meeting to help explain it! 7