3 assignments
The Financing Decision
Chapter Six
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Higgins, Analysis for Financial Management, 12e
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Selecting the Proper Financing Instruments
Step 1: Determine how much financing is required.
Step 2: Choose the instrument to be sold.
The focus of the financing decision should be to support the company’s strategy.
Ch. 6 2
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Choices
If a firm requires $200 million in external financing, should it issue new debt or new equity?
If equity financing is not an alternative, how much debt should the firm issue?
How does the firm’s financing decision today impact its situation in the future?
Ch. 6 3
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Things to Keep in Mind
Do not assume there is a single right answer to any of these questions.
OPM is other people’s money.
How does OPM affect:
risk-return relationships in a corporate setting?
tax implications?
financial distress?
signaling effects?
Ch. 6 4
Higgins, Analysis for Financial Management, 12e
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Financial Leverage
Think about jacking up a car.
Most people cannot lift a heavy car with their bare hands.
A jack is a lever that uses increased distance to amplify effort.
But using a jack, the car will go up a small distance when a person pushes the handle down a greater distance.
Financial leverage is like that, using increased risk to amplify expected return.
Ch. 6 5
Higgins, Analysis for Financial Management, 12e
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Example of Leverage
Examine Table 6.1.
$1,000 outlay
Two possible investment outcomes
Probabilities are 50-50
Panel A illustrates 100% equity financing.
Panel B illustrates debt financing.
How does debt financing impact the return to owners (shareholders) in the two outcomes, and on average?
Ch. 6 6
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TABLE 6.1 Debt Financing Increases Expected Return and Risk to Owners
Ch. 6 7
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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The Bottom Line
Increased debt lowers the initial investment required by shareholders.
Increased debt amplifies the expected return.
Increased debt amplifies the risk faced by shareholders.
That’s what financial leverage is all about.
Operating leverage, featuring high fixed costs, but low variable costs, works the same way.
Ch. 6 8
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A Revised Equation for ROE
Here iʹ is the after-tax cost of debt, (1-t)i.
Notice that for an unlevered firm, ROE is just ROIC.
Ch. 6 9
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Favorable and Unfavorable Outcomes
Comparing ROIC to iʹ tell us whether the company’s assets generate a return that exceeds the after-tax cost of debt.
If ROIC > iʹ , then leverage increases ROE.
If ROIC < iʹ , then leverage decreases ROE.
Ch. 6 10
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It’s Not So Easy
In 2016, only 63% of publicly traded, nonfinancial firms earned a return above borrowing cost.
For larger firms with sales above $200 million, 71% accomplished this feat.
Figure 6.1 illustrates the impact of leverage on both risk and expected return.
Ch. 6 11
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FIGURE 6.1 Leverage Increases Risk and Expected Return
Ch. 6 12
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Highlights from Figure 6.1
Leverage shifts expected return to the right.
Leverage flattens the distribution, shifting probability to the extremes.
Bankruptcy lies at the left extreme.
Leverage of 2-to-1 pushes the lower tail from -12 to -40 for the same operating income.
Ch. 6 13
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Hasbro: Debt or Equity?
Stable, profitable, conservatively financed, uses assets efficiently
Hypothetical opportunity: the acquisition of a toy company in China for $1.8 billion
How should they finance the acquisition?
Equity: 20 million shares @ $90/share
Debt: $1.8 billion of 5% bonds
Ch. 6 14
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Other points
EBIT expected to reach $1 billion with the acquisition.
Ch. 6 15
Dividends expected to be $2.35 per share.
Higgins, Analysis for Financial Management, 12e
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TABLE 6.2 Selected Information about Hasbro’s Financing Options in 2017 ($ millions)
Ch. 6 16
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Leverage and Risk
Can use pro forma analysis
Can use ratios
Important to gross up after-tax amounts to before tax-amounts by dividing after-tax amounts by 1−t, where t is the corporate tax rate
Look at 3 coverage ratios, involving the payment of interest, principal, and dividends, where coverage is for 1, top 2, or all 3 payments.
Ch. 6 17
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TABLE 6.3 Hasbro’s Projected Financial Obligations and Coverage Ratios in 2017 ($ millions)
Ch. 6 18
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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% EBIT Can Fall
When a coverage ratio drops below 1.0, the company is in danger of not being able to make its payments from operating cash flows.
Ask by what % can EBIT fall before a ratio drops to 1.0
The larger the % EBIT can drop, the less risk the company faces.
Consider how debt financing impacts % that EBIT can fall.
Ch. 6 19
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Calculating % EBIT Can Fall
Times interest earned = EBIT/Int. Exp.
TIE falls to 1.0 when EBIT falls to IE.
So the % EBIT can fall is given by:
(EBIT–IE)/EBIT
1–1/TIE
(TIE–1)/TIE
Similar for times burden covered: (TBC–1)/TBC
Ch. 6 20
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Ch. 5 21
You try it. Calculate the percentage that EBIT can fall before coverage drops below 1.0 for YAMAHA.
| YAMAHA Corporation 2016 | ||
| Coverage | % EBIT can fall | |
| Times interest earned | 23.4 | |
| Times burden covered | 1.9 |
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For TIE, 22.4/23.4 = 96%
For TBC, 0.9/1.9 = 47%
21
Compare With Industry Figures
How do D/A and TIE vary across industries?
See Table 6.4.
Indebtedness rising overall in recent years.
How do the firm’s ratios stack up against the industry data?
Table 6.5 enables the firm to ballpark itself in respect to bond rating.
Ch. 6 22
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TABLE 6.4 Average Corporate Debt Ratios 2007–2016 and Industry Debt Ratios 2016
Ch. 6 23
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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TABLE 6.5 Median Values of Key Ratios by Standard & Poor’s Rating Category
Ch. 6 24
If Hasbro issues bonds, what rating would you expect it to have?
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Leverage and Earnings
How are the two financing schemes likely to affect reported income and ROE?
To answer this question, look at pro forma statements for the two plans, under two different conditions, boom and bust.
See Table 6.6.
This table displays the bottom portion of a pro forma income statement.
Ch. 6 25
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TABLE 6.6 Hasbro’s Partial Pro Forma Income Statements in 2017 ($ millions except EPS)
Ch. 6 26
Does debt or equity lead to higher overall earnings?
Is debt or equity more favorable in a boom period?
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Interest Tax Shields
Notice the difference in the tax bill in Table 6.6.
If t = tax rate and I = interest payment, then the product t × I measures the tax savings or tax shield from debt.
Many believe this is the chief attraction of debt financing.
Ch. 6 27
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Ch. 5 28
You try it. Calculate Aetna’s annual interest tax shield from this bond offering.
Note: Assume Aetna’s tax rate is 40%.
Higgins, Analysis for Financial Management, 12e
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Annual tax shield = tI = 0.4 × (750,000,000 × 0.035) = $10,500,000
28
Crossover Analysis
Figure 6.2 in the next slide illustrates how variation in EBIT impacts ROE.
E = shareholder equity
Equation for ROE is linear in EBIT with slope of (1−t)/E and intercept of –iD(1−t)/E.
Look for the bust point, the boom point, the crossover, and the expected EBIT point.
What do the differing slopes tell us?
Ch. 6 29
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FIGURE 6.2 Range of Earnings Chart for Hasbro
Ch. 6 30
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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How Much to Borrow?
What level of debt financing is best for a firm?
M&M’s irrelevance principle in the absence of taxes and transaction costs, firm’s debt levels do not impact value.
Total cash flows generated over time are the basis for the firm’s value.
The debt-equity split only determines how this value is apportioned between holders of debt and holders of equity.
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Real World Issues
Taxes and transaction costs are part of the real world.
What are the various items to take into consideration when making decisions about financing with debt or equity?
Figure 6.3 provides a capsule summary.
Ch. 6 32
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FIGURE 6.3 The Higgins 5-Factor Model for Financing Decisions
Ch. 6 33
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Tax Benefits
Interest is tax deductible.
Lowering the tax bill leaves more left over for all investors, meaning the pool of shareholders and debtholders.
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Distress Costs
Increased debt leads to higher expected costs associated with financial distress.
Ch. 6 35
Bankruptcy costs debt can turn a mild inconvenience into a major problem involving:
major legal expenses, and/or
the sale of company assets at fire sale prices
Higgins, Analysis for Financial Management, 12e
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Assets
Can assets be sold off, thereby lowering the probability of bankruptcy and leaving a reasonable amount for shareholders of the bankrupt entity?
It depends on the assets.
Are they hard or soft?
Do they walk out the door at the end of the day?
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Indirect Costs
Indirect costs come in many forms:
Lost profit opportunities from cutbacks to R&D
Lost sales as customers bail, fearing difficulties down the line
Suppliers bail out for fear that the firm won’t pay its bills
Competitors become more aggressive
Ch. 6 37
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Conflicts of Interest
When times are rough and bankruptcy looks like it’s just around the corner, it might be reasonable for a firm to “go for broke.”
If “go for broke” fails, debtholders will pick up the tab.
If the “go for broke” works, equity holders benefit and bankruptcy is averted.
This behavior was part of the S&L crisis in the 1980s.
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Anticipation
Debtholders are not stupid.
They anticipate what might happen if a firm winds up in financial distress, and demand compensation up front in the form of higher interest rates.
Firm’s managers should also anticipate what might happen down the line, if its debt weakened the firm, and new potential customers were frightened off.
Ch. 6 39
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Summary Checklist
When making financing choices, keep the following in mind:
The ability of the company to use additional interest tax shields over the life of the debt
The increased probability of bankruptcy stemming from added leverage
The cost to the firm if bankruptcy occurs
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Observed debt ratios, selected industries
Ch. 6 41
Do you see any patterns consistent with the trade-off between tax benefits and distress costs?
Source: Damodaran online, 2017
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Flexibility
Credit squeezes happen.
A firm might not be able to borrow to stay competitive, when it needs it most to fund an important investment opportunity.
For this reason, firm managers must think about being financially flexible.
Cash is king, so finance while it’s possible, using equity if it’s available and not too expensive.
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Issue Debt or Restrict Growth?
Remember that g* = PRAT, where T is based on prior shareholders’ equity.
The connection to financing is through R and T.
Increasing retention and increasing leverage both lead to increased g*.
Therefore, the firm faces a tradeoff, since issuing less debt and paying additional dividends to shareholders will lower growth.
Ch. 6 43
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What Is the Prudent Thing to Do?
Financial managers should recognize the true risks they confront, and balance the benefits of higher leverage against the costs of higher leverage.
Too high a T will heighten the risk that critical management decisions will fall into the hands of creditors, who have interests of their own.
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Equity and Flexibility
Remember that financial flexibility might argue for equity financing.
Lenders are wary about lending to companies whose D/E ratio is already high, because the probability of default for these firms is higher.
Keeping D/E on the low side serves as a buffer to help the firm raise new debt more easily if necessary.
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Market Signaling
When companies announce that they intend to raise new equity, their stock prices drop.
Ch. 6 46
On average, the drop in value is about one third the size of the new issue.
Announcements about new debt have a much more neutral impact.
Announcements about stock repurchases result in a stock price increase.
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Dilution?
Does issuing new equity lower EPS?
It can, if earnings stay the same but the number of shares goes up.
But why would earnings stay the same if the money raised from the new stock issue was put to good use?
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Rosy Outlook
If the outlook is rosy, relative to what they would be otherwise, increased leverage:
raises g*
increases EPS
Look again at Figure 6.2.
If the outlook is not rosy, then increased equity produces these same two effects.
Therefore, what does a new equity issue suggest?
Ch. 6 48
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FIGURE 6.2 Range of Earnings Chart for Hasbro
Ch. 6 49
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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What Do the Tea Leaves Say?
Managers know more about a firm’s future prospects than investors.
If the market hears that a firm plans to issue new equity, should it conclude that managers have a rosy outlook?
Is it any surprise that stock prices fall when firms announce their intention to issue new equity?
Vice versa for share repurchases?
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Opportunistic Issues
Managers might issue new equity when they view current equity as being overpriced.
Investors understand the situation, and ask for protection in the form of a lower stock price.
Therefore, managers who view the true outlook to be rosy are stuck.
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Pecking Order
Managers might respond to these issues with a “pecking order” rule.
They fund new projects with existing cash, before turning to external sources.
If they fund externally, they fund first with debt.
They use equity only as a last resort.
Ch. 6 52
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Management Incentives
Being human, managers look out for #1 (themselves) before shareholders.
Ch. 6 53
Their actions increase private value for themselves at the expense of shareholder value.
Aggressive debt financing can put the heat on managers, reducing the extent of this value transfer possible without risking financial distress for the firm.
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One View of Management Incentives
Ch. 6 54
“Every company has got people sitting around who do nothing for what they get paid. If they take on a lot of debt, it forces them to cut fat.”
– Joseph Perella, financier
quoted in Michael Lewis, Liar’s Poker
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Financing Decision and Growth
The financing decision should weigh the relative importance of the five factors.
For rapidly growing businesses, remember to make financing subservient to operations as a source of value creation.
This means prudent debt policies.
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What Prudence Means
Conservative leverage ratio with ample unused borrowing capacity
A modest dividend payout policy to preserve cash
If investment needs temporarily exceed funds generated by internal operations, draw down cash and use debt as a backstop.
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More Prudent Steps
Do not issue debt if it jeopardizes financial flexibility.
Sell equity rather than jeopardize financial flexibility.
Constrain growth only as a last alternative.
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Low Growth Firms
Slow growth companies have an easier time with financing decisions.
They have excess operating cash flows.
Financial flexibility is not an issue.
Market signaling is not an issue.
They can use the company’s healthy operating cash flow as a magnet to borrow, and then repurchase shares.
Ch. 6 58
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Benefits of Debt
The company will have increased interest tax shields, if it is profitable.
A share repurchase announcement will be warmly greeted by the market, and the firm’s stock price will go up.
The higher debt will inject additional discipline in respect to management incentives.
Ch. 6 59
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Hasbro: More Debt?
Does increased debt make sense for them?
Financial flexibility?
Management incentives?
Distress costs?
What to do with the extra cash?
Ch. 6 60
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Selecting a Maturity Structure
What is the right maturity for debt?
The minimum risk maturity structure is to match the maturity of the liabilities against the maturity of the operating income from the firm’s assets.
This makes the liabilities self-liquidating.
If the debt matures too soon, there is refinancing risk.
If the debt matures too late, the company must manage the cash until maturity.
Ch. 6 61
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Why Mismatch?
Debt with the right maturity is unavailable
Mismatching will reduce total borrowing costs
Beware market timing in efficient markets
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Inflation and Financing Strategy
During inflationary times, debts get repaid with cheaper dollars.
Investors who expect inflation ask for higher interest rates to compensate them for the inflation they expect.
Only if inflation is unexpected is it true that debtors gain at the expense of debtholders.
The deflation story is the reverse.
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Appendix: Irrelevance Proposition
Table 6A.1 contrasts the irrelevance proposition in the case of no taxes, and in the case of taxes.
Timid is an unleveraged firm; Bold is a leveraged firm.
The analysis shows how personal leverage might substitute for corporate leverage.
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Items of Note
Retention rate = 0
Bold is 80% debt financed
Equity investment required for the two firms
Rate of return on equity investment
Rate of return on personal investment
Extent to which homemade leverage can substitute for corporate leverage
Impact of taxes on issues above
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TABLE 6A.1 In the Absence of Taxes, Debt Financing Affects Neither Income nor Firm Value; In the Presence of Taxes, Prudent Debt Financing Increases Income and Firm Value
Ch. 6 66
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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TABLE 6A.1 In the Absence of Taxes, Debt Financing Affects Neither Income nor Firm Value; In the Presence of Taxes, Prudent Debt Financing Increases Income and Firm Value (cont.)
Ch. 6 67
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Higgins, Analysis for Financial Management, 12e
Higgins, Analysis for Financial Management, 12e
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Industry
Debt/Capital
Tax rate
Stock volatilityFixed assets/Total assets
Software (Internet)11.25%3.49%55.85%13.80%
Electronics (Consumer & Office)30.57%3.81%66.94%9.90%
Software (Entertainment)34.94%1.04%48.14%3.46%
Drugs (Pharmaceutical)36.74%2.54%67.61%11.16%
Healthcare Products38.15%6.12%56.59%11.35%
Telecom. Equipment39.47%6.14%49.24%6.97%
Computers/Peripherals42.79%5.68%60.29%8.40%
Heathcare Information and Technology42.84%6.32%52.46%9.34%
Retail (Online)44.56%8.46%48.86%20.06%
Auto Parts47.54%10.40%50.64%25.95%
Chemical (Diversified)50.28%6.59%45.48%29.73%
Air Transport55.52%22.99%38.61%56.28%
Utility (General)58.60%25.62%19.32%69.65%
Transportation58.87%17.46%32.72%46.36%
Retail (Grocery and Food)59.43%24.11%35.13%55.33%
Power61.61%19.27%24.11%67.82%