BUS4098 Week 4

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Financial Decisions

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Business Simulation

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Capital Structure Effects

The simulation includes several ways in which investors evaluate your firm's performance. For stockholders and bondholders, there is particular interest in those aspects of a firm's performance that determine the value of their capital investments. Although their propensities may be different, both these groups want maximum returns at the lowest risk. From a management perspective, being able to deliver this performance makes capital available to the firm in the future at very desirable rates. The simulation's use of stock price and bond ratings reflects these desires.

You can manage these desires by managing the capital structure of the firm—the mix of stocks and bonds that appears on the right of the balance sheet. The choices you make in terms of the capital structure of the firm will have a huge effect on how satisfied bondholders and stockholders are. You may have already discovered how bondholders respond when cash flow is tight and the times interest earned rate shrinks. As the bond ratings fall, the cost of capital increases. Similarly, you know how stock investors respond to a firm’s performance on stock exchanges by bidding the price per share up or down. If you issue new stock, you find that with a high stock price, you can raise capital by issuing only a few new shares and, therefore, cause minimal dilution of each existing shareholder's interest.

When you make the final decisions, you should be in a position to adjust the capital structure of the firm to take advantage of the preferences of both these groups. Clearly, the strategic success your team has had until now will have a large impact on what you can do to polish your balance sheet. But most teams will be able to make some meaningful improvements that will be reflected in their performance metrics by the end of the course.

First, we will look at your debt options and their implications, and then we will look at the choices that are made around your firm's stock.

Using Different Debt Options

Using debt is one of the most important financial tools that managers have at their disposal. Debt obligations are a source of financial leverage that can amplify a firm's stock price in good times or bankrupt a firm in poor times. Clearly, the goal is to take advantage of as much of the positive leverage that debt provides. However, too much debt puts both bondholders and stockholders at risk. With a tool this powerful, managers have to be careful how they use it.

Debt-to-Equity and Times Interest Earned Ratios

The two most important metrics that a firm possesses with respect to its debt levels are its debt-to-equity (D/E) ratio and its times interest earned (TIE) ratio. The latter changes every year based on cash flow. Good cash flow management can produce a high ratio and make bondholders confident that their interest payments will be made in full and on time. This results in a low bond rating and availability of cheaper capital for expansions and other long-term projects.

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Business Simulation

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The D/E ratio is the long-term strategic goal that underpins your debt strategy. You set the D/E ratio with an eye on the average TIE ratio that your firm is likely to produce and also on the variation in the TIE ratio that you can tolerate. In particular, you would want to have a TIE ratio that is acceptable in a down year. So, how high can you go with a D/E ratio? This will depend on both the industry volatility and on your management skills.

Use of Debt by a Strong Firm

If you have done a good job of establishing a strong position in the footwear industry, then your firm should be assured of a good cash flow in most years. Importantly, a strong cash flow will allow you to have sufficient cash reserves to cover any debt obligations in a particularly poor period. In business stories about firms that are reporting a poor year, you will often find a clear statement of their cash on hand. You should not be surprised that well-established firms usually have a significant amount of cash or near-cash items on their balance sheet.

If you are in the position just described, you may want to consider whether your D/E ratio is too low. By switching equity for debt—usually by issuing debt to buy back stock or exclusively using debt for capital expansions—a firm obtains financial leverage. Financial leverage can greatly increase the value of a share of stock. Because interest payment to debt holders is fixed, they do not share any increase in profits produced by a good strategy. Debt holders only receive their interest payment. However, with fewer stockholders, the earnings per share (EPS) ratio can increase dramatically. This is because the numerator increases and at the same time, the denominator decreases.

Let us now discuss the use of debt by a weak firm.

Use of Debt by a Weak Firm

If your firm is not in a highly stable situation, then you may want a low D/E ratio. Remember, you have to make your interest payments first. If you have more equity and little debt, it means that your profits are spread over more stockholders. However, you do not risk bankruptcy in a poor year because you have small interest obligations to satisfy. So again, you come back to cash flow and TIE.

There is a ripple effect here which firms that are in a weak position need to avoid. When a firm's performance lags for a year, it leads to a strain on the firm's free cash flow due to its interest obligations. As free cash disappears into the bondholders' pockets, the firm has to turn elsewhere for cash to grow. Often, the answer is to go back to the debt market.

However, with a low TIE ratio, the new bonds or short-term back credit will come at a high interest rate. This, in turn, increases the fixed interest payment obligations of subsequent years. If a second poor year occurs in a row, the process repeats. Eventually, the TIE ratio falls below one, and there is no cash reserve from previous years to pay the interest due. At this point, the firm falls into a technical, if not actual, bankruptcy.

Let us take up an example to understand this well.

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Business Simulation

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Example: Too Much Risk in Las Vegas

The danger of too much debt relative to equity can be seen in the gaming industry in the United States. Large casinos and resort projects were built in Las Vegas and Atlantic City in the 1990s. These mega- projects often cost up to or over $1 billion. The managers of these firms counted on the large free cash flow of the casino operations to support a high D/E ratio. As long as the cash flow was sufficient, the small equity base of the firms would enjoy high earnings per share.

However, all the firms did not employ good strategies. When the expected cash flow failed to emerge, they got into trouble quickly. The large interest payments meant that managers had very little time to develop and implement new strategies before the firms defaulted. The result was that several firms went into bankruptcy, and the stockholders lost their investments, instead of receiving the benefits of financial leverage.

An interesting additional result is that even the firms in this industry that employ good strategies and make their interest payments on time, often have to pay a high interest rate. Their bonds are listed at rates below investment grade—junk bonds—because the membership in an industry such as this is seen by many debt holders as risky.

Working with the three-year plan this week, your team can look at the what-if impacts of more debt in your balance sheet. But be realistic about the likelihood of a down year of weaker-than-ideal performance. You can be sure that your stock and bond investors will be looking at this.

Paying Dividends and Buying Back Stock

Now, let us shift the focus of the discussion to equity and stockholders. How do we get the most for the stockholders—the people who actually own the firm?

Stockholders can benefit from stock ownership in two ways—capital gains and dividends. Dividends have been in the news lately due to changes in the tax law. The simulation reflects this change, which allows dividends to be taxed at a rate lower than ordinary income for many taxpayers. Paying dividends to your stockholders will increase your stock price. However, you need to have a clear dividend policy. Paying dividends is voluntary unlike debt interest, but it does reduce the cash or cash-like assets of the firm. Therefore, you don't want to increase your default risk in poor years by paying out too much in dividends in good years.

Click here to learn more about dividend tax rates.

Stockholders come to expect dividends, therefore, firms are often conservative in their dividend policy. Many successful firms do not pay dividends even after knowing that these payments will increase their stock prices. For firms that pay dividends, the payout rate should be one that can be sustained in the weak years. Failing to sustain a dividend after it is established is one of the clearest signs that management can send to stockholders that there is a crisis. Make sure that in conducting your team's what-if analysis, you determine whether the dividend policy you establish can endure a couple of poor years.

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The other way in which equity owners benefit is through capital gains due to stock price increases. We saw how effective use of debt creates financial leverage that will help the price rise in good years. This same leverage also reduces gains in weak years. You can achieve the biggest gains when the growth of your firm takes place through execution of a superior strategy against your rivals. But firms often use another tool to increase stock price—stock buyback.

Be sure to contrast stock buybacks with actual strategy. There is nothing in a buyback that improves a firm's competitive position. The only thing buyback does is reduce the equity base of the firm. This, in effect, increases the D/E ratio and hence, the leverage of the firm. But this leverage increase does not occur through any increase in debt or interest obligations. Therefore, while the D/E ratio increases, the TIE ratio does not change. This is seen as a safe way of obtaining leverage, and it does not trigger tax consequences for stockholders that dividends do. However, it does use up the cash, which the firm would otherwise have on hand.