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Oregon Lease Purchase Agreement with Option

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									Capital Structure: Overview
of the Financing Decision


        05/12/08
         Ch. 7
Corporate finance decisions revisited
 Corporate finance consists of three major
  decisions:
     Investment decision

     The financing decision
          Where do firms raise the funds for value-creating
           investments?
          What mix of owner’s money (equity) or borrowed
           money(debt) should the firm use?

     Dividend decision
                                                               2
Measuring a firm’s financing mix
 The simplest measure of how much debt and equity a firm is
   using currently is to look at the proportion of debt in the total
   financing. This ratio is called the debt to capital ratio (or simply
   the debt ratio):

        Debt to Capital Ratio = Debt / (Debt + Equity)

 Debt includes all interest bearing liabilities, short term as well as
   long term.

 Equity can be defined either in accounting terms (as book value
   of equity) or in market value terms (based upon the current
   price). The resulting debt ratios can be very different.
                                                                          3
    Debt versus Equity
    •The differences between debt and equity lies in the nature of the stakeholders’
    claims on the firm’s cash flows, tax treatment, maturity and voting power


                         Debt versus Equity

Fixed Claim                                           Residual Claim
High Priority on cash flows                           Lowest Priority on cash flows
Tax Deductible                                        Not Tax Deductible
Fixed Maturity                                        Infinite life
No Management Control                                  Management Control



 Debt                                Hybrids (Combinations             Equity
                                     of debt and equity)

                                                                                      4
Equity choices for private firms
 Private firms have fewer choices for raising
  equity capital

 Owner’s Equity
   Retention and plow back of company’s
    earnings
   Similar in nature to retained earnings of a
    public company in terms of taxability, residual
    claim, management control


                                                      5
Equity choices for private firms
 Venture Capitalist
    VCs provide equity financing to small and risky
     businesses in return for a share in ownership of the
     firm

      VC ownership is a function of
         Capital contribution

         Financing options available to the business



      VC provides
         Managerial and organizational skills

         Credibility of venture to potential capital providers



                                                                  6
Equity choices for public firms
 The public firm has more alternatives for
  raising equity

 Common Stock
     Initial public offerings (IPOs) – raising equity
      capital publicly for the first time
     Seasoned equity offerings (SEOs) –
      subsequent issues of common stock


                                                         7
Equity choices for public firms
 Common Stock
   Firms may issue common stock that is uniform
    in offering price and voting rights or;
   Firms may create classes of shares to:
          Create differential voting rights so that owners
           maintain control of the firm
          Cater to different clientele that are in different tax
           brackets

     Common stock issues tend to decline as a
      means of raising capital as the firm matures
                                                                    8
Equity choices for public firms
 Tracking stock
     Stock issued against specific assets or
      portions of the firm
     May allow investors to buy portions of a firm
      that have the greatest potential
     Typically do not provide investors with voting
      rights




                                                       9
Equity choices for public firms
 Warrants
     Provides investors with the option to buy
      equity at a fixed price in the future in return for
      paying for the warrants today

     Can be attractive because
          No immediate financial obligation to firm
          No immediate dilution of ownership



                                                        10
Debt financing options
 Bank debt
     Borrowing from a bank at an interest rate
      charged by the bank based on the borrowing
      firm’s perceived risk


 Advantages of bank debt (versus bonds):
     Can be issued in small amounts
     Allows firm to maintain proprietary information
     Does not require being rated

                                                        11
Debt financing options
 Bonds
    Borrowing from the public by issuing debt


 Advantages of bonds
    Typically carry more favorable terms than bank debt
    Allows issuers to add on special features



 When issuing bonds, firms have to make a variety of
  choices including maturity, fixed or floating interest
  payment, secured or unsecured.

                                                           12
Debt financing options
 Leasing
     Firm (lessee) commits to making fixed
      payments to the owner (lessor) for the right to
      use the asset
     Payments may be fully tax deductible



     Provides firms with an alternative to buying
      capital assets

                                                        13
Debt financing options
 Leasing
    Operating lease
       Shorter term

       present value of the lease payments is generally much
        lower than the price of asset
       Ownership resides with the lessor

       Lease expense is treated as an operating expense

       Off-balance sheet financing



      Capital lease
         Lasts the lifetime of the asset

         Lessee is responsible for insurance and taxes on the
          asset
         For tax purposes, capital leases are equivalent to
          borrowing and buying the asset, consequently,
          depreciation and interest expense are shown as         14

          expenses on the income statement
Debt financing options
 Leasing
      Reasons provided for leasing
           Firm has insufficient borrowing capacity

           Bond covenants restrict firms from taking on more
            conventional debt

           Operating leases tend to provide firms with greater
            profitability ratios since operating expense will typically be
            lower than if the asset was purchased and the lease is not
            included as part of the firm’s capital

           Differential tax rates – an entity with a higher tax rate will
            benefit more from buying the asset. This high-tax entity can
            then lease the asset to a lower / no tax entity and can share
            the tax benefits

                                                                             15
Debt financing options
 Leasing
     The decision to lease or borrow/buy should be
      based on the incremental after-tax cash flows

     Operating lease cash flows:

             Lease payments * (1 – t)



                                                  16
Debt financing options
 Leasing
     Borrow/Buy cash outflows
          Interest expense (after tax)
          Principal payments (non-tax deductible)
          Maintenance expenses (after tax)


     Borrow/Buy cash inflows
          Depreciation tax benefit (t*Depreciation)
          Salvage value (after tax)


                                                       17
Debt financing options
 Leasing
     The net advantage to leasing

  NPV of lease option – NPV of buy option

  Where cash flows are discounted at the after tax
   cost of debt since both represent borrowing
   alternatives and cash flows are calculated on
   an after-tax basis

                                                 18
Hybrid securities
 Financing choices that have characteristics of
  both debt and equity are referred to as hybrid
  securities




                                               19
Hybrid securities
 Convertible debt
    Can be converted by the bondholder to a
     predetermined number of shares of common stock

      The conversion option:
         Conversion ratio = number of shares for which each

          bond may be exchanged
         Conversion value = current value of shares for which

          the bonds can be exchanged
         Conversion premium = excess of bond price over

          conversion value


                                                                 20
Hybrid securities
 Convertible debt
     Reasons for issuing convertible debt
          Investors will require a lower required return, thus
           allowing firms to set a lower coupon rate
              Particularly useful for high-growth companies

          Reduces the conflict between equity and bond
           holders




                                                                  21
Hybrid securities
 Preferred stock
     Generates fixed payment obligations by the
      firm
     Cost more to raise than debt

     Reasons for issue
          Analysts and rating agencies treat preferred stock
           as equity for calculating leverage



                                                            22
Financing
 We now look at the distinction between
  internal and external financing and the factors
  that affect how much firms draw on each
  source and how firms decide between their
  external financing choices.

 Internal Financing – funds raised from cash
  flows of existing assets
 External Financing – funds raised from
  outside the company (VC, debt, equity, etc.)

                                                 23
Internal vs. External Financing
 Firms may prefer internal financing because
      External financing is difficult to raise
      External financing may result in loss of control
      Raising external capital tends to be expensive

 Projects funded by internal financing must
  meet same hurdle rates

 Internal financing is limited
                                                      24
A Life Cycle View of Financing
Choices
                                                                                                                                         Revenues
     $ Revenues/
     Earnings


                                                                                                                                         Earnings



                                                                                                                                         Time




Externa l fu nding          High, but              High, relative           Moderate, relative   Declining, as a
needs                                                                                                                 Low, as projects dry
                            constrained by         to firm value.           to firm value.       percent of firm
                                                                                                                      up.
                            infrastructure                                                       value


In terna l finan cing        Negative or            Negative or             Low, relative to     High, relative to    More than funding needs
                            low                    low                      funding needs        funding needs


Externa l                   Owner’s Equity         Venture Capital          Common stock         Debt                 Retire debt
Finan cing                  Bank Debt              Common Stock             Warrants                                  Repurchase stock
                                                                            Convertibles

Growth stage                Stage 1                Stage 2                    Stage 3            Stage 4              Stage 5
                            Start-up               Rapid Expansion            High Growth        Mature Growth        Decline                       25
Finan cing
Tra nsition s           Accessing private equity   Inital Public offering       Seasoned equity issue   Bond issues
Process of raising capital
 Private firm expansion


 From private to public firm: The IPO


 Choices for a public firm




                                         26
VC process
 Provoke equity investors’ interest
    There is an imbalance between the number of small
     firms that desire VC investment and the number of VCs

      Firms need to distinguish themselves from others to
       obtain VC funding

      Type of business
         Dot.com in the 90s, bio-tech firms this decade




      Successful management

                                                             27
VC process
 Perform valuation and return assessment (Venture capital
  method)
    Estimate earnings in the year the company is expected to go
     public

      Obtain a P/E multiple for public firms in the same industry

        Exit or Terminal Value = P/E multiple * forecasted earnings

      Discount this terminal value at the VC’s target rate of return

        Discounted Terminal Value = Estimated exit value
                                    (1 + target return)n

                                                                        28
VC process
 Structure the deal
     Determine the proportion of firm value that VC
      will get in return for investment
       Ownership Proportion = Capital Provided
                                   Disc. Exit Value

     VC will establish constraints on how the
      managers run the firm


                                                   29
VC process
 Participate in post-deal management
    VCs provide managerial experience and contacts for
     additional fund raising efforts


 Exit
    VCs generate a return on their investment by exiting
     the investment.
    They can do so through
        An initial public offering

        Selling the business to another firm

        Withdrawing firm cash flows and liquidating the firm



                                                                30
VC process
 Stages of Venture Capital Investments
   Seed financing is capital provided at the “idea”
    stage.
   Start-up financing is capital used in product
    development.
   First-stage financing is capital provided to initiate
    manufacturing and sales.
   Second-stage financing is for initial expansion.
   Third-stage financing allows for major expansion.
   Mezzanine financing prepares the company to go
    public.

                                                            31
Going public vs. staying private
 The benefits of going public are:
     Firms can access financial markets and tap
      into a much larger source of capital
     Owners can cash in on their investments

 The costs of going public are:
     Loss of control
     Information disclosure requirements
     Exchange listing requirements
                                                   32
Initial Public Offering (IPO) process
 Most public offerings are made with the assistance of
  investment bankers (IBs) which are financial
  intermediaries that specialize in selling new securities
  and advising firms with regard to major financial
  transactions.




                                                         33
IPO process
 The role of the investment banker
      Origination - design of a security contract that is acceptable
       to the market;
           prepare the state and federal Securities and Exchange
            Commission (SEC) registration statements and a summary
            prospectus,

      Underwriting-the risk-bearing function in which the IB buys
       the securities at a given price and turns to the market to sell
       them.
           Syndicates are formed to reduce the inventory risk.

      Sales and distribution-selling quickly reduces inventory risk.
       Firm members of the syndicate and a wider selling group
       distribute the securities over a wide retail and institutional
       area.

                                                                         34
IPO process




              35
IPO process
 IPO costs

      Underwriting commission (usually around 7%)

      Underpricing of issue
           Represents the first day returns generated by the firm,
            calculated as
                                      Closing Price – Offer price
                                               Offer price

           Issues are underpriced to
               Provide investors with a “good taste” about the investment banker
                and firm
               Compensate investors for the information asymmetry between
                firm and investor

                                                                                36
IPO process
 Valuing the company and setting issue details
     Investment banker and firm need to determine
          Value of company
             Valuation is typically done using P/E multiples
          Size of the issue
          Value per share
          Offering price per share
             This will tend to be below the value per share, i.e.,
              the offer will be underpriced



                                                                      37
IPO process
 Determining the offer price
   The investment banker will gauge the level of
    interest from institutional investors for the
    issue by conducting road shows. This is
    referred to as building the book.

 After the offer price and issue details are set,
  and the SEC has approved the registration,
  the firm places a tombstone advertisement
  in newspapers, that outlines the details of the
  issue and the investment bankers involved
                                                     38
IPO process
 Waiting period – The period between the submission
  of the registration to the SEC and the SEC’s
  approval. It is during this time that the company
  releases the red herring

 Quiet period – a period after the registration is
  submitted until approximately a month after the issue
  where the company cannot comment on the
  earnings, prospects for the company

 Lock-up period – a period of usually 6 months
  following the issue date in which the insiders of the
  company cannot sell their shares

                                                          39
Choices for a publicly traded firm
 General subscription (or Seasoned Equity
  Offering)

 Private placements


 Rights offerings




                                             40
General subscription (SEO)
 Although for IPOs the underwriting agreement almost
  always involves a firm guarantee from the underwriter
  to purchase all of the issue, in secondary offerings,
  the underwriting agreement may be a best efforts
  guarantee where the underwriter sells as much of
  the issue as he can

 SEOs tend to have lower underwriting commissions
  because of IB competition.

 The issuing price of an SEO tends to be set slightly
  lower than the current market price
                                                         41
Private placement
 Securities are sold directly to one or few
  investors

 Saves on time and cost (no registration
  requirements, marketing needs)

 Tends to be less common with corporate
  equity issues. Private placement is used more
  in corporate bond issues.
                                               42
Rights offerings
 Existing investors are provided the right to purchase
  additional shares in proportion to their current
  holdings at a price (subscription price) below
  current market price (rights-on price)

 Each existing share is provided one right.

 The number of rights required to purchase a share in
  the rights offering is then determined by the number
  of shares outstanding and the additional shares to be
  issued in the rights offering.

      rights required to purchase one share = # of original shares
                                            # of shares issued in RO
                                                                       43
Rights offerings
 Because investors can purchase shares at a lower price, the rights
   have value:

         Value of the right = rights-on price – subscription price
                                         n+1

         where n = number of rights required for each new share

 Because additional shares are issued at a price below market price, the
   market price will drop after the rights offering to the ex-rights price

                   ex-rights price = New value of equity
                                        New number of shares

 The value (or price) of the right can also be calculated as:

                   rights-on price – ex-rights price
                                                                             44
Rights offerings
 Costs are lower because of
    Lower underwriting commissions – rights offerings tend
     to be fully subscribed
    Marketing and distribution costs are significantly lower


 No dilution of ownership


 No transfer of wealth




                                                            45
The financing mix question
 In deciding to raise financing for a business,
  is there an optimal mix of debt and equity?
      If yes, what is the trade off that lets us
       determine this optimal mix?
      If not, why not?




                                                    46
Costs and benefits of debt
 Benefits of Debt
     Tax Benefits
     Adds discipline to management
 Costs of Debt
     Bankruptcy Costs
     Agency Costs
     Loss of Future Flexibility



                                      47
Tax benefits of debt
 Interest paid on debt is tax deductible, whereas cash
  flows to equity have to be paid out of after-tax cash
  flows.

 The dollar tax benefit from the interest payment in
  any year is a function of your tax rate and the interest
  payment:
     Tax benefit each year = Tax Rate * Interest Payment




                                                           48
The effects of taxes
You are comparing the debt ratios of real estate corporations,
  which pay the corporate tax rate, and real estate investment
  trusts, which are not taxed, but are required to pay 95% of their
  earnings as dividends to their stockholders. Which of these two
  groups would you expect to have the higher debt ratios?
 The real estate corporations
 The real estate investment trusts
 Cannot tell, without more information



                                                                 49
Implications of the tax benefit of
debt
 The debt ratios of firms with higher tax rates should be higher
   than the debt ratios of comparable firms with lower tax rates.

 Firms that have substantial non-debt tax shields, such as
   depreciation, should be less likely to use debt than firms that do
   not have these tax shields.

 If tax rates increase over time, we would expect debt ratios to go
   up over time as well, reflecting the higher tax benefits of debt.

 We would expect debt ratios in countries where debt has a
   much larger tax benefit to be higher than debt ratios in countries
   whose debt has a lower tax benefit.


                                                                       50
Debt adds discipline to
management
 Free cash flow (or cash flow to equity) represents cash flow
   from operations after all obligations have been paid.

 It represents cash flow for which management has discretionary
   spending power.

 Without discipline, management may make wasteful
   investments with free cash flow because they do not bear any
   costs for making these investments.

 Forcing firms with free cash flow to borrow money can be an
   antidote to managerial complacency.

 Empirical evidence is consistent with the hypothesis that       51
   increasing debt improves firm performance.
Debt and discipline
Assume that you buy into this argument that debt adds discipline to
   management. Which of the following types of companies will
   most benefit from debt adding this discipline?
 Conservatively financed (very little debt), privately owned
   businesses
 Conservatively financed, publicly traded companies, with stocks
   held by millions of investors, none of whom hold a large percent
   of the stock.
 Conservatively financed, publicly traded companies, with an
   activist and primarily institutional holding.
                                                                 52
Bankruptcy cost
 Bankruptcy is when a firm is unable to meet its contractual
  commitments.
 The expected bankruptcy cost is a function of two variables--
    the cost of going bankrupt
           direct costs: Legal and other administrative costs (1-5% of
            asset value)
           indirect costs: Costs arising because people perceive you to be
            in financial trouble – loss of revenue, stricter supplier terms,
            capital raising difficulties


    the probability of bankruptcy, which is a function of the size
     of operating cash flows relative to debt obligations and the
     variance in operating cash flows
 As you borrow more, you increase the probability of bankruptcy
  and hence the expected bankruptcy cost.                           53
Indirect bankruptcy costs should be
highest for….
 Firms that sell durable products with long
 lives that require replacement parts and
 service



 Firms producing products whose value to
 customers depends on the services and
 complementary   products supplied  by
 independent companies

                                           54
The bankruptcy cost proposition and
implications
 Proposition:
    Other things being equal, the greater the indirect
     bankruptcy cost and/or probability of bankruptcy in the
     operating cash flows of the firm, the less debt the firm
     can afford to use.

 Implications:
    Firms operating in businesses with volatile earnings
     and cash flows should use debt less than otherwise
     similar firms with stable cash flows.
    Firms with assets that can be easily divided and sold
     should borrow more than firms with assets that are less
     liquid.
                                                                55
Agency cost (conflict between
stockholder and bondholder)
 When you lend money to a business, you are
  allowing the stockholders to use that money
  in the course of running that business.
  Stockholders interests are different from your
  interests, because
     You (as lender) are interested in getting your
      money back
     Stockholders are interested in maximizing
      their wealth

                                                       56
Agency cost (conflict between
stockholder and bondholder)
 In some cases, the conflict of interests can
  lead to stockholders
     Investing in riskier projects than you would
      want them to
     Paying themselves large dividends when you
      would rather have them keep the cash in the
      business.




                                                     57
Agency cost proposition
 Other things being equal, the greater the
  agency problems associated with lending to a
  firm, the less debt the firm can afford to use.




                                                58
What firms are most affected by
agency cost?
 Agency costs will tend to be the greatest in firms whose
  investments cannot be easily monitored or observed

 Agency costs will tend to be the greatest for firms whose
  projects are long-term, unpredictable or will take years to come
  to fruition.




                                                                59
How agency costs show up...
 If bondholders believe there is a significant chance that
  stockholder actions might make them worse off, they can build
  this expectation into bond prices by demanding much higher
  rates on debt.

 If bondholders can protect themselves against such actions by
  writing in restrictive covenants, two costs follow –

      the direct cost of monitoring the covenants

      the indirect cost of lost investments



                                                             60
Loss of future financing flexibility
 When a firm borrows up to its capacity, it
  loses the flexibility of financing future projects
  with debt.

 Financing Flexibility Proposition:
       Other things remaining equal, the more
       uncertain a firm is about its future financing
       requirements and projects, the less debt the
       firm will use for financing current projects.

                                                        61
What managers consider important in
deciding on how much debt to carry...
 A survey of Chief Financial Officers of large U.S. companies
   provided the following ranking (from most important to least
   important) for the factors that they considered important in the
   financing decisions
Factor                                           Ranking (0-5)
1. Maintain financial flexibility                4.55
2. Ensure long-term survival                     4.55
3. Maintain Predictable Source of Funds          4.05
4. Maximize Stock Price                          3.99
5. Maintain financial independence               3.88
6. Maintain high debt rating                     3.56
7. Maintain comparability with peer group        2.47

                                                                      62
Debt: Summarizing the Trade Off

          Advantages of Borrowing                  Disadvantages of Borrowing
 1. Tax Benefit:                            1. Bankruptcy Cost:
 Higher tax rates --> Higher tax benefit    Higher business risk --> Higher Cost
 2. Added Discipline:                       2. Agency Cost:
 Greater the separation between managers    Greater the separation between stock-
 and stockholders --> Greater the benefit   holders & lenders --> Higher Cost
                                            3. Loss of Future Financing Flexibility:
                                            Greater the uncertainty about future
                                            financing needs --> Higher Cost


                                                                                   63
A qualitative analysis of the firm’s
debt ratio
 Tax benefits:
       What is the firm’s tax rate?
      Does the company have substantial tax shields?
   Discipline:
      Does management own shares?
      Does the firm have significant free cash flows?
   Bankruptcy:
      How volatile are the firm’s earnings and cash flows?
      How liquid and divisible are the firm’s assets?
      How would you assess the firm’s indirect bankruptcy costs
        (perception of the consumer)?
   Agency:
      Are the firm’s investments easily monitored?
      Are the investments short term or long term?
   Financial Flexibility:
      What stage of life cycle is the firm in?


                                                                   64
How do firms set their financing
mixes?
 Life Cycle: Some firms choose a financing mix that reflects
  where they are in the life cycle; start- up firms use more equity,
  and mature firms use more debt.

 Comparable firms: Many firms seem to choose a debt ratio that
  is similar to that used by comparable firms in the same
  business.

 Financing Heirarchy: Firms also seem to have strong
  preferences on the type of financing used, with retained
  earnings being the most preferred choice. They seem to work
  down the preference list, rather than picking a financing mix
  directly.

                                                                       65
Comparable firms
 When we look at the determinants of the debt ratios
  of individual firms, the strongest determinant is the
  average debt ratio of the industries to which these
  firms belong.

 This is not inconsistent with the existence of an
  optimal capital structure. If firms within a business
  share common characteristics (high tax rates, volatile
  earnings etc.), you would expect them to have similar
  financing mixes.


                                                          66
Rationale for financing hierarchy
 Managers value flexibility. External financing
  reduces flexibility more than internal
  financing.

 Managers value control. Issuing new equity
  weakens control and new debt creates bond
  covenants.



                                                   67
Preference rankings : Results of a
survey
   Ranking      Source                   Score
   1          Retained Earnings          5.61
   2          Straight Debt              4.88
   3          Convertible Debt           3.02
   4          External Common Equity     2.42
   5          Straight Preferred Stock   2.22
   6          Convertible Preferred      1.72

                                                68

								
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