. 32
( 39)


’$66 +$433

Exec Comp Accrual $868 $851 $1,036
’$17 +$185

Restructuring Actions $589 $1,024 $871
+$435 ’$153

Postemployment, preretirement $493 $579

+$80 +$7

na †
Disability Bene¬ts na $349

+$0 +$45

Environmental Accruals $215 $208 $214
’$7 +$6

Other $670 $731

+$96 +$268

Total $5,465 $7,456

+$486 +$1, 175

— †
This revision shifted $330 from deferred income into other liabilities, which can be seen in Table 24.3. IBM
broke out $330 million disability bene¬ts in 2003, previously classi¬ed as “other.”

To put the interest paid into perspective, in 2001, IBM earned $7.7 billion; in 2002, it earned
$5.3 billion; in 2003; it earned $7.6 billion. To put the credit lines into perspective, they are
about equal in size to IBM™s long-term debt.
¬le=capclinical.tex: LP
630 Chapter 24. Clinical Observations About Capital Structure .

24·3. IBM™s Equity

Table 24.5 shows most of the evolution of IBM™s equity. (There is not enough information
Changes in the number
of shares ultimately in the footnotes to track all changes.) Looking at preferred equity, we see that it must have
were minor.
disappeared by 2002. The background is that in 1995, the IBM board had decided to repurchase
all its remaining 7.5% callable preferred stock, and this was ultimately completed on May 18,
2001. Moving on to common equity, we note that although 1.9 billion shares of IBM were
o¬cially outstanding, IBM itself held about 200 million shares in 2001 and 2002, and 250
million shares in 2003. Thus, if you had owned about 1.7 billion external shares, you would
have owned all of IBM™s common equity. Interestingly, this number remained fairly constant.
Yes, IBM actively repurchased its shares, and although the dollar amount was large, it was
only a small fraction of the company™s outstanding stock. In addition, IBM then turned around
and used these shares in other transactions, e.g., to fund the PwCC acquisition or to fund its
employee stock option plans. Consequently, although repurchases and net stock transactions
were larger than interest payments and dividend payments combined, the active issuing or
repurchasing of shares ultimately did not play much of a role.
Instead, almost all the change in the value of equity came through the one mechanism of
Changes in the price per
share played a very large changes in the price of each IBM share: from 2001 to 2002, it dropped from $120.96 to
$77.50, thereby losing about one-third of its market value. From 2002 to 2003, the market
value bounced back again by about 20%.
¬le=capclinical.tex: RP
Section 24·3. IBM™s Equity.

Table 24.5. IBM™s Equity and Some Other Information

2001 2002 2003
Preferred authorized 150,000,000 “ “
outstanding 2,546,011 “ “

Common authorized 4,687,500,000 4,687,500,000 4,687,500,000
outstanding 1,913,513,218 1,920,957,772 1,937,393,604
7 , 444, 554
Change 16, 435, 832

treasury 190,319,489 198,590,876 242,884,969
Change 8, 271, 387 44, 294, 093

Net 1,723,193,729 1,722,366,896 1,694,508,635
’826, 833 ’27 , 858, 261

Identi¬able Changes
’3, 677 , 213
PwCC Acquisition Issue, restricted

’24, 037 , 354
To Pension Fund, from Treasury

Repurchase I 48, 481, 100 49, 994, 514

Repurchase II ESOP 189, 797 291, 921

’979, 246 ’2, 120, 293
Issue to ESOP, from Treasury

PwCC Acq Issue— ’$254

Repurchase I $4, 212 $4, 403

Repurchase II ESOP $18 $24

’$1, 871
To Pension Fund

Retained Earnings $30,142 $31,555 $37,525
Book Equity $23,448 $22,782 $27,864

Cash Dividends Paid $1, 005 $1, 085

Common Stock Transactions $3, 087 $3, 232

$831 $853
For Comparison: Interest Paid

$1, 707 $1, 841
For Perspective: Taxes Paid

Common Price/Share $120.96 $77.50 $92.68
’ Common Market Value $208,437 $133,484 $157,047

An additional $30 million is recorded to be issued in future.
¬le=capclinical.tex: LP
632 Chapter 24. Clinical Observations About Capital Structure .

24·4. Assessing IBM™s Capital Structure Change

We can now make some overall observations. IBM™s liabilities evolved fairly steadily. About
Where changes came
from. one-quarter of the total debt were pension and other liabilities. The pension obligations, in par-
ticular, marched upwards fairly steadily. In terms of IBM™s total debt increase, the pension and
other obligations accounted for one-third and three-quarters in 2002 and 2003, respectively.
About one-quarter of IBM™s total liabilities were its long-term debt; one-half was its short-term
debt. In 2002, IBM ratcheted up its medium-term notes borrowing, accounting for a debt in-
crease of $3.5 billion. In 2003, IBM mostly kept its borrowing at the same level, but shifted
it relatively from long-term into current debt. These changes in the value of IBM™s debt were
dwarfed by the changes in the value of IBM™s equity”and almost all of these came from changes
in the per-share price, not from changes in the number of shares outstanding.
Solve Now!
Q 24.1 How would you de¬ne the ¬rm™s capital structure?

Q 24.2 List some of the bigger factors that go into the ¬rm™s capital structure.

Q 24.3 To purchase all common equity in a ¬rm, do you need to purchase all outstanding shares?

Q 24.4 Is debt or equity value usually “spikier”?

24·5. The Capital Structure of Other Firms

Obviously, we cannot look at all publicly traded companies at the same level of detail as we did
for IBM. Still, you need to know not just the needle, but also the haystack. Is IBM a representative
¬rm, or is it the exception? What are the debt ratios of companies of di¬erent size? Are there
any patterns?

24·5.A. Very Large Firms

Let™s start with the largest U.S. traded ¬rms on Yahoo!Finance. Table 24.6 shows the 28 ¬rms
Let™s look at the 28
largest ¬rms traded in in 2005 that had more than $100 billion in entity value at the end of 2005. Entity value is
the U.S. Let™s focus on
Yahoo™s term for total debt plus market value of equity. It is not the same as assets, because it
market value, not book
is only the sum of the market value of equity and ¬nancial debt net of cash assets. It ignores
all other liabilities. As noted, our focus is on market-value-based debt ratios.
Eleven companies were primarily in ¬nance-related businesses, one was a large conglomerate,
Financial ¬rms tend to
have high debt/equity two were in car manufacturing (though ¬nancing car purchases could be a large part of their
ratios. Non-¬nancial U.S.
business), and fourteen were in other businesses. IBM is one of the latter. The table shows that,
¬rms that are not in
just like IBM, most of these large ¬rms have market values that are two or three times their
¬nancial distress tend to
have very low leverage.
book values. A quick glance suggests the following:

Financial Firms have very high debt ratios. The most extreme example is Fannie Mae, a mort-
gage lender, which is also the world™s largest ¬rm. It has outstanding debt obligations of
$940 billion, twenty times its equity capitalization. (In turn, most of its assets are loans
to home owners.) But many banks and other ¬nancial companies also have more debt
than equity.

Car Manufacturers also have relatively high debt-equity ratios. As of 2005, the two remaining
U.S. car manufacturers (General Motors and Ford) are both in real distress. This is why
their equity market values are not two or three times their book value”in fact, GM™s
¬le=capclinical.tex: RP
Section 24·5. The Capital Structure of Other Firms.

book value is now above its market value. This is a rarity among large U.S. companies.
Most of GM™s and Ford™s remaining assets today are loans extended to customers who are
purchasing vehicles.

Non-Financial Firms Many of the remaining large U.S. ¬rms have market-based debt/equity
ratios that are in the single digits. The two outliers are Verizon and AT&T, both of which
have recently made large acquisitions. (Verizon bought MCI; SBC purchased AT&T and
changed its name to AT&T.) IBM does not seem unusual, but it also is among the more
indebted companies. (IBM has large ¬nancial ¬nancing operations, which may explain
some of this.)

General Electric is hard to classify.

24·5.B. Smaller Firms

Even these 28 companies are not fully representative of companies in the U.S. economy. There We want to learn
debt/equity ratio
are thousands of smaller ¬rms. Unfortunately, we cannot look one-by-one at their individual
patterns by ¬rm size.
capital structures. So, we need to summarize the information. I propose we look at non-
¬nancial companies in 2003, classi¬ed as follows:

Name Total Firm Market Value Median Size Number
“Tiny Firms” Less than $100 million $35 1,341
“Small Firms” $100 million to $1 billion $350 2,195
“Medium Firms” $1 billion to $10 billion $4,360 1,597
“Large Firms” More than $10 billion $52,409 606

The ¬nal category is basically the ¬rms in the S&P500 index, and include the ¬rms analyzed
in the previous subsection. Although our main interest are these ¬rms™ debt ratios, let us also
look at some other relevant ratios.

Debt Components
You have already seen that you can base debt ratios only on the ¬nancial debt or on all liabil- Small Firms have
relatively lower ¬nancial
ities. How do the two compare? We shall also discuss the averages against the IBM estimate,
so that you can intuitively compare magnitudes and judge whether the IBM numbers were

Financial Debt vs. Total Liabilities In 2003, IBM had $23.632 billion in ¬nancial debt, out of
total liabilities of $76.593 billion. Thus, just over 30% of its debt was ¬nancial. Was IBM
representative, at least among larger ¬rms?

Financial / Total Liabilies Tiny Small Medium Large IBM

Median, 2003 24% 27% 46% 45% 30%
25th -75th Percentile Range 0-53% 0-54% 25-63% 30-56%

This shows that IBM™s 30% ratio is relatively small among large companies. More typically,
large ¬rms have just under half of their total liabilities in ¬nancial debt. In contrast, small
¬rms tend to have relatively more non-¬nancial liabilities. (And many small ¬rms have
no ¬nancial liabilities.)
¬le=capclinical.tex: LP
634 Chapter 24. Clinical Observations About Capital Structure .

Table 24.6. U.S. Firms in December 2005 with at least $100 billion in Entity Value

Ticker Company Total Entity Fin™l Debt Equity Debt/Equity
(MV) (BV) (BV) (MV) (BV) (MV)

Primarily Financial and Insurance Operations
FNM Fannie Mae 985 940 22 47 4,270% 2,020%
FRE Freddie Mac 713 716 27 46 2,618% 1,550%
BAC Bank of America 311 425 101 188 420% 225%
AIG Amer Intl Group (AIG) 238 116 89 176 129% 66%
WFC Wells Fargo & Co 180 102 40 107 257% 96%
C Citigroup 177 516 111 249 466% 207%
WM Washington Mutual 143 115 25 43 456% 267%
WB Wachovia 114 123 47 83 263% 148%
SLM SLM (Sallie Mae) 111 89 3 23 2,745% 387%
USB US Bancorp 108 59 20 56 299% 106%
AXP American Express 102 44 10 65 445% 68%

Car Manufacturers and Conglomerates, incl. large ¬nancing arms
General Electric—
GE 722 360 113 374 319% 96%
GM General Motors 274 278 22 11 1,241% 2,612%
F Ford Motor 140 142 14 15 1041% 958%

Primarily Non-Financial Operations
XOM Exxon Mobil 338 8 108 354 8% 2%
MSFT Microsoft 244 0 48 282 0% 0%
WMT Wal Mart Stores 236 38 50 202 76% 19%
MO Altria Group 177 25 35 159 72% 16%
PFE P¬zer 176 12 67 177 18% 7%
JNJ Johnson And Johnson 168 2 37 181 7% 1%
PG Procter&Gamble 161 30 13 139 228% 21%
IBM IBM 144 21 30 131 71% 16%
INTC Intel 143 1 37 157 2% 0%
CVX Chevron 131 14 60 128 23% 11%
VZ Verizon Communic 122 39 39 85 101% 47%
GOOG Google 118 0 9 127 0% 0%
BRK-A Berkshire Hathaway 105 15 90 136 17% 11%
T AT&T Inc. 103 23 38 81 60% 29%

Yahoo!Finance reports long-term debt plus debt in current liabilities as overall debt, and quotes entity (or enterprise)
value as the sum of ¬nancial debt and the market value of equity, minus cash and short-term holdings. It ignores
all other liabilites.
¬le=capclinical.tex: RP
Section 24·5. The Capital Structure of Other Firms.

If it is not through ¬nancial debt, then how do small ¬rms borrow? Do they use more “day-to- Smaller ¬rms rely more
on trade credit.
day” borrowing than large ¬rms, and, in particular, more trade credit? They do:

Short-Term Liabilities vs. Total Liabilities Of IBM™s $76.593 billion in total liabilities, $37.9
billion was short-term.

Short-Term / Total Liab. Tiny Small Medium Large IBM

Median, 2003 77% 63% 37% 37% 50%
25th -75th Percentile Range 49-98% 36-89% 22-59% 23-51%

IBM sits on the high end among large companies. More typically, large ¬rms have only
about one-third of their total liabilities in short-term liabilities. In contrast, small ¬rms
tend to have two-thirds of their liabilities in short-term liabilities. Small ¬rms, indeed,
seem to live more precariously than large ¬rms.

Accounts Payables vs. Total Liabilities IBM had $8.46 billion in accounts payables.

Payables / Total Liab. Tiny Small Medium Large IBM

Median, 2003 19% 15% 10% 10% 11%
25th -75th Percentile Range 10-34% 7-28% 5-19% 5-14%

Here, IBM was typical for large ¬rms. In contrast to such large ¬rms, many small ¬rms
¬nance themselves relatively more through trade credit.

Equity Value Measures
Our next question concerns the e¬ect of quoting equity in terms of market or book values. If Book values are lower
than market values.
all ¬rms have similar book/market value ratios, then a market-value based debt-ratio is always
the same fraction of a book-value based debt-ratio, and the indebtedness rank of a company
relative to other companies would not depend on how you quote indebtedness.

Book Value vs. Market Value of Equity IBM had a market value of equity of $157.047 billion,
and a book value of $27.864 billion.

Book Equity / Market Equity Tiny Small Medium Large IBM

Median, 2003 46% 45% 40% 39% 18%
25th -75th Percentile Range 16-90% 25-72% 24-58% 21-60%

IBM was relatively low on this ratio”such ¬rms are sometimes called growth ¬rms. Book
values tend to be below market values for all types of ¬rms, although there is much
variation across ¬rms even within size categories. Thus, ¬rms will rank di¬erently in
terms of indebtedness depending on how you quote the book value.
¬le=capclinical.tex: LP
636 Chapter 24. Clinical Observations About Capital Structure .

Debt Ratios
Our main interest is ultimately debt ratios.
Debt ratios are bigger
for larger ¬rms

Ratio of Financial Debt To Equity (MV) In 2003, IBM had ¬nancial debt of $23.632 billion and
equity valued at $157.047 billion.

Financial Debt / Equity Ratio Tiny Small Medium Large IBM

Median, 2003 14% 27% 41% 41% 15%
25th -75th Percentile Range 0-70% 1-117% 12-112% 15-113%

For a ¬rm of IBM™s size, 15% is low”although we know from Table 24.6 that such low
¬nancial debt-equity ratios are more common among the 28 largest ¬rms than they are
among the largest 600 ¬rms. In contrast, small ¬rms are commonly not ¬nanced primarily
through ¬nancial debt.

Ratio of Total Liabilities vs. Asset Value (MV) In 2003, IBM had total liabilities of $76.593 bil-
lion on a total market value of assets of $233.640 billion”just about 33%.

Liabilities / Asset Ratio Tiny Small Medium Large IBM

Median, 2003 30% 23% 35% 40% 33%
25th -75th Percentile Range 14-53% 10-47% 19-53% 24-59%

IBM™s overall liability asset ratio is fairly common, however. In contrast, small ¬rms are
typically less indebted.

We can dissect the liabilities ratio further. I looked at all 416 non-¬nancial ¬rms with more
Recent performance and
industry seem to matter. than $10 billion in assets. There were only twelve ¬rms with debt ratios above 90%. Four ¬rms
were airlines (United, Delta, Northwest, American); three were car manufacturers or suppliers
(GM, Ford, Goodyear); three were energy-related (Calpine, CMS Energy, Mirant). The ¬nal two
were Charter Cable and Owens-Corning (which had been forced into bankruptcy by its asbestos
liabilities). All of them had experienced dramatic declines in their equity values in the prior two
years, and were either close to or in bankruptcy. Visual examination of other highly indebted
¬rms shows that this pattern continues. Among the next forty ¬rms with the highest debt
ratio, three quarters were in energy, a sector that had su¬ered a terrible year. Of the remaining
quarter, the majority of ¬rms were car-related. We can also look at the 191 ¬nancial ¬rms.
These had a median debt ratio of 55%”much higher than the 40% reported in the table for
the 416 non-¬nancial ¬rms. In sum, industry and recent stock market performance seem to
¬le=capclinical.tex: RP
Section 24·6. Summary.

24·6. Summary

This chapter covered the following major points:

1. Capital structure can be measured in many di¬erent ways. The most important choices
are whether market value is measured in terms of book value of equity value, and whether
indebtedness is measured in terms of total liabilities or just ¬nancial debt.

2. Both capital scale and capital structure dynamics are in¬‚uenced by factors under manage-
ment™s immediate control (such as debt issuing or share repurchasing), factors related to
operations (such as pension obligations and working capital), and factors beyond man-
agement™s immediate control (such as value changes, aka stock returns).

3. The big liability categories are often long-term debt, short-term debt, pension liabilities
(depending on the company), and other liabilities.

4. Financial debt can appear both in long-term debt and short-term debt. It can contain many
di¬erent types of borrowings simultaneously”bonds, notes, foreign credit, hybrid secu-
rities, credit line related borrowing, bank debt, etc. Firms also report the term structure
of their liabilities.

5. Short-term debt contains ¬nancial debt, tax obligations soon due, accounts payalble, com-
pensation related liabilities, and other items.

6. Firms can and often do take the term structure into account when they issue or retire
debt. This is often history dependent.

7. Other liabilities can contain such items as deferred taxes and deferred income, executive
compensation, retirement-related items, disability bene¬ts, environmental liabilities, etc.

8. Equity is less colorful than debt. For many companies, it is only one class of common

When we look at a broader section of publicly traded ¬rms in 2003, we ¬nd that

1. Industry matters. Many ¬nancial ¬rms have very high debt ratios. Many pharmaceutical
and computer companies have very low debt ratios.

2. Distressed ¬rms and ¬rms recently having acquired other ¬rms often have high debt

3. Large ¬rms not in the preceding two categories often have very low debt ratios”as low
as the single digits.

4. Large ¬rms tend to have relatively more of their total debt in ¬nancial obligations (45%)
than small ¬rms (25%).

5. Large ¬rms tend to have relatively less of their total debt in short-term obligations (35-
40%) than small ¬rms (60-70%). Small ¬rms rely disproportionally more on trade credit
(20% vs. 10%.)

6. Typical ¬nancial debt-to-equity ratios are around 15-25% for small ¬rms, and 40% for large

7. The book value of equity is on average less than half its market value. Therefore, book-
based debt-asset ratios are often two or three times as high as market-based debt-asset

8. Small ¬rms tend to have ¬nancial-debt to equity ratios of about 15-30%; large ¬rms about
¬le=capclinical.tex: LP
638 Chapter 24. Clinical Observations About Capital Structure .

9. Small ¬rms tend to have total liabilities equivalent to 30% of their assets (market value);
large ¬rms tend to have about 40%.
¬le=capclinical.tex: RP
Section 24·6. Summary.

Solutions and Exercises

1. Usually, this is a debt/equity ratio.
2. Debt consists of long-term debt (bonds and notes), short-term debt (¬nancial, taxes, payables, etc.), pension-
debt, and other debt. Equity is a number of shares multiplied by the per-share value.
3. No! Many ¬rms have treasury shares, which they themselves hold.
4. Equity.

(All answers should be treated as suspect. They have only been sketched, and not been checked.)
¬le=capclinical.tex: LP
640 Chapter 24. Clinical Observations About Capital Structure .
The Dynamics of Capital Structure and Firm Size

The Issuing and Financing Process
last ¬le change: Mar 30, 2006 (13:02h)

last major edit: Apr 2005

You know the factors that in¬‚uence optimal capital structure, and you have a general idea of
how ¬rms™ liabilities structures look like. But knowing where it should be or where it is does
not mean that you already know how ¬rms get there. So, how do corporations actually arrive
at their current capital structures? And, is it all under the control of managers?
This chapter gives you a basic framework of how to think about the capitalization process of
the ¬rm, how changes in debt-equity ratios come about, and some other institutional details
that are relevant to the capital issuing process. The next chapter is closely linked, in that it
will lay out what we know empirically about how actual corporate capital structure has been
developing in the United States.

25·1. The Dynamics of Capital Structure and Firm Scale

You already know that a ¬rm™s capital structure is comprised of the claims on its assets. These Most forces are as you
would expect”what
claims are typically a mix of various forms of debt (long-term, short-term, operating-related),
management chose.
equity (common and preferred), and hybrid claims (e.g., convertibles). You also know the forces
that managers should be aware of when they think about the value-maximizing mix of these
claims”forces like taxes and agency concerns. These theories and considerations are mostly
about the capital structure levels. As the ¬rm operates, both its needs and its debt and equity
levels are changing. In the remainder of this chapter, we concentrate on these capital structure
changes. Table 25.1 organizes many of the relevant forces tugging on the ¬rm™s debt-equity
ratio and the ¬rm™s scale (total value). Many of these are the usual suspects”transactions
stemming from active ¬nancial market intervention, as orchestrated by the CFO.
But not every change is under the control of management. We have already noted these factors Stock returns are not
fully under the control
in IBM™s case. Table 25.1 ignores many of the in¬‚uences operating on the ¬rm™s capital structure
of management.
(and in particular, its liabilities, such as pension liabilities). We still have left one factor that is
not fully under the ¬nancing control of the CFO: ¬rm value changes (aka stock returns), which
a¬ect both the scale and the debt-equity ratio of the ¬rm. For example, a ¬rm that is ¬nanced
50-50 by risk-free debt and equity and that doubles would see its debt-equity ratio decline to
50-150. We have already seen the e¬ects of stock returns in IBM™s case”when its stock price
tumbled from $121 to $78 per share, its equity lost over one-third of its value. This, in turn,
dramatically increased IBM™s debt ratio. What factors might in¬‚uence the stock price? Some
are beyond the manager™s control. For example, investors could become more risk-averse and
therefore would no longer be willing to pay $121 for IBM with its level of risk. Other factors
that can change IBM™s value would be unexpectedly good or bad news (an earthquake). There
are also factors that are under the manager™s control. Perhaps the ¬rm paid out a lot of equity
in dividends to shareholders (OK, we know IBM did not!), or managers ran the ¬rm poorly.
Table 25.1. Non-Operating Capitalization and Capital Structure In¬‚uences

Firm Value

Decreases Constant Increases

¬le=capdynamics.tex: LP
(Exogenous) Firm Value Rise
(possibly through retained earnings)

Primary Seasoned Equity Issue in M&A
Debt Repurchase (e.g., sinking fund and
Debt-into-Equity Conversion.
interest payment)
Share Creation for Employee Compen-
Decreases Equity-for-Debt Exchange (more
Repayment of Principal or Interest
sation Purposes
equity, less debt; often used in
Chapter 11)
Debt Call
Primary Seasoned Equity Issue outside
Debt-Equity Ratio

Chapter 25. The Dynamics of Capital Structure and Firm Size.
M&A context

Warrant Exercise

Simultaneous Debt-Equity Issue.—
Simultaneous Debt-Equity Payout.—
Hybrid Security Issue.—

(Exogenous) Firm Value Drop
Debt-for-Equity Exchange (more
Share Repurchase Debt Issue
debt, less equity)
Cash Dividend

Sale of Assets (e.g., carveout) Purchase of Assets (e.g., M&A)

Boldfaced changes are common, though not necessarily of equal quantitative importance. Starred transactions rarely occur in the precise proportionality to maintain a constant debt-equity

Note that this table ignores the complex interaction with existing capital structure. In particular, if the ¬rm is 100% equity ¬nanced, an increase or decrease in ¬rm value, an equity issue
or equity repurchase, and a dividend payment have no in¬‚uence on the ¬rm™s debt-equity ratio”it will remain at 0%.
¬le=capdynamics.tex: RP
Section 25·2. The Managerial Perspective.

(Large publicly traded ¬rms cover about 50-90% of their funding needs with retained earnings.
The remainder is usually predominantly debt-¬nanced.) As you will see in the next chapter, a
considerable proportion of most ¬rms™ debt-equity dynamics is determined by such ¬rm value
changes, which are re¬‚ected most obviously in the ¬rm™s stock price.

Side Note: Table 25.1 not only does not mention changes in operating liabilities, but also ignores the e¬ect
of bond price changes. When economy-wide interest rates rise or the ¬rm™s credit rating deteriorates, the debt
usually declines in value”but so does the equity. Conversely, when economy-wide interest rates drop or the
¬rm™s credit rating appreciates, the debt usually increases in value”but again, so does the equity. Thus, the
e¬ect of changing interest rates on the debt-equity ratio is usually ambiguous. Moreover, there are situations
in ¬nancial distress in which the debt wrestles power from the equity”there would be no change in overall
capitalization, but a good change in the ¬rm™s debt-equity ratio.

Solve Now!
Q 25.1 Is all debt at the discretion of management?

Q 25.2 Describe some of the ¬nancial factors that can change capital structure

25·2. The Managerial Perspective

In this section, assume that you are the CFO of a large ¬rm who wants to achieve an optimal An outline.
capital structure. You will be dealing with the forces and mechanisms outlined in Table 25.1,
and then some. But you are not helpless. Your current capital structure is at least in part the
outcome both of your predecessors™ and your own actions. In light of the constant historical
change of your capital structure, what questions and issues should be on your mind when you
think about your active capital policy for this year?

25·2.A. The Holistic View

As CFO, should you think narrowly about just one action”say, whether to repurchase shares? Don™t think “dividends,
yes or no?” Think
Probably not. Table 25.1 should make it clear that you should consider components not in
instead of capital in¬‚ows
isolation, but within a broader context. It would make more sense for you to think about the vs. out¬‚ows; and of debt
overall payin/payout policy of the ¬rm. Dividends, coupon payments, repurchases, and issues vs. equity consequences.
are all mechanisms for transferring cash from inside the corporation to the outside owners,
or vice-versa. To think about the overall debt-equity policy of the ¬rm, you should recognize
that equity issues, debt repurchases, and interest payments are all mechanisms for lowering
the ¬rm™s debt-equity ratio.
Here is an illustration of the multidimensional nature of your choices. For simplicity™s sake, An example of a ¬rm.
start by assuming we are still in a perfect M&M market, where the mix of ¬nancing does not
in¬‚uence total ¬rm value. Your ¬rm is currently worth $1 billion, of which $400 million is
outstanding debt. You may choose to raise $100 million in new equity, raise $200 million in
new debt, pay out $30 million to service old debt (principal and interest), pay out $20 million
in dividends, and repurchase $50 million of the ¬rm™s own equity shares. De facto, your ¬rm

1. transferred $100 + $200 ’ $30 ’ $20 ’ $50 = $200 million of cash from the outside to
the inside,

2. and increased its debt-equity ratio from $400:$600≈67% to $570:$630≈90%.

Of course, the real world is not M&M, and this means that you need to amend your choices. You
need to consider the reaction of investors. For example, if investors believe that the corporation
su¬ers badly from agency con¬‚ict, then they may react negatively (to the $200 million increase
in extra cash available to managers). On the other hand, if investors believe that the higher debt-
equity ratio will save the corporation relatively more in taxes, then they may react positively
¬le=capdynamics.tex: LP
644 Chapter 25. The Dynamics of Capital Structure and Firm Size.

to the increase in the debt-equity ratio. In fact, you should consider each and every value
e¬ect that we discussed in Chapters 21“23. Without knowing more about our particular ¬rm,
it would be hard to guess whether the ¬nancial markets would look fondly or not so fondly on
these capital structure changes. Why does this matter? If your capital structure rearrangement
created value, for example, it might well be that the outcome is not $1.2 billion in value and
$570:$630 in debt-equity ratio, but, say, $1.3 billion in value and a $570:$730 debt-equity ratio.
(In the web chapter on capital market responses, we will look in some depth at how U.S. ¬nancial
markets have responded to corporate actions.)
Can you think of equity-issuing activity as a decrease in the ¬rm™s debt-equity ratio? It is easy
An important
interaction! to mentally equate the two, but this is not necessarily the case. There are two basic disconnects
to consider.

1. The existing capital structure plays an important role in the e¬ect that issuing has on the
capital structure. When a ¬rm with a 100% equity structure issues new equity shares, it
does not change its debt ratio. But the same equity issue would induce drastic capital
structure changes for an equal-sized ¬rm that was previously 90% debt-¬nanced. Thus,
even if there were no other in¬‚uences, studying equity issues is intrinsically not the same
as studying debt-equity decreases.

2. An in¬‚uence may have an e¬ect through multiple channels. For example, contemplated
M&A activity may induce equity-issuing activity”but it also induces debt-issuing activity.
Thus, M&A activity may not necessarily positively in¬‚uence debt-equity ratios at all.

In addition, you already know that there are many other factors in¬‚uencing ¬rms™ debt-equity
ratios, which have nothing to do with equity issuing. Thus, although equity-issuing and de-
creases in the ¬rm™s debt-equity ratio are linked, studying (equity-) issuing activity is by no
means the same as studying capital structure.
Before we move on, there is one last interesting capital structure e¬ect worth noting. Your
Important secondary
effects. investors would also draw some inferences from the fact that our sample ¬rm paid out only
$20 million in dividends, but repurchased $50 in shares. Dividends tend to be stickier than
share repurchases, and thus the fact that your ¬rm pays out more in repurchases than in
dividends may send a mixed signal”either managers want to be smart about tax consequences
(good news), or they are worried about the ¬rm™s ability to pay out cash again next year (bad
news). (We will talk about these non-obvious e¬ects later when we zero in on individual actions
in more detail.)

25·2.B. Meaningful Questions

So, as CFO, what are the most important questions concerning your target capitalization that
The two important
questions. you should ask? Is it just the question whether you should pay dividends, repurchase shares,
or issue equity? You already know that payin/payout policy is a complex issue, but stating this
is not much help to you. Ultimately, capital policy really has to be considered on a ¬rm-by-¬rm
basis. If you want to act on behalf of the ¬rm™s owners, these are the questions that you must

1. Can you invest the money better than what your investors can ¬nd elsewhere?

2. If you are taking an action (e.g., paying out less cash or taking in more cash), do your
investors share your beliefs that this will increase value”that the additional money will
be well spent?
If your investors agree with your managerial judgment, as they would in a perfect market,
then there is no problem. However, if your investors disagree with you, as they may in
an imperfect market, then there is a problem. For example, if you know that investing
in a new technology is highly worthwhile but requires cutting dividends, the market may
react negatively. This means that all investors would be taking a hit on their market value
right now, just as they would if you had thrown away money. If you are correct, investors
¬le=capdynamics.tex: RP
Section 25·2. The Managerial Perspective.

will eventually realize the value gain, and thus the share price will appreciate again. But
this is little consolation to those investors who have to sell their shares this year. Should
you represent your current investors or your future investors? There is no easy answer to
this di¬cult question. But note that agency theorists are often skeptical about claims that
managers weighed choices and decided to represent the long-run investors”they believe
that such claims are often only excuses for managers to represent only themselves. But
everyone agrees that good communication from managers to investors can only help.

In any case, these two questions should point out to you that even our holistic view of capital Worry about operations
and disclosure.
policy is still too narrow. Capital structure has intricate links to the ¬rm™s project opportunities,
corporate governance, and disclosure policy. If the ¬rm has great opportunities, if managers
are well motivated, and if the ¬rm can convince investors of these great opportunities, then the
answer to both questions is often yes. Such ¬rms can even create value by reducing dividends
and share repurchases and raising more equity. If the answer to both questions is no, then the
¬rm should not issue equity, and instead seek to increase dividends and share repurchases.
And if the answers to both questions are fuzzy”as they often are”then you have a tough
judgment call to make.

25·2.C. Financial Flexibility and Cash Management

But in many corporations, and especially smaller ones, the CFO faces one issue more important Don™t run out of money!
than even long-run capital policy. It is cash management”and fortunately, your goal here is
easy and straightforward: Don™t let the company run out of cash! We do not mean cash in the
cash register, but rather cash necessary to pay creditors. There are many intrinsically prof-
itable companies”especially young, high-growth companies”that have had to fold because
of poor liquidity management. The need to pay creditors does not necessarily mean that your
company has to have lots of cash on hand. It is enough if you can borrow with ease and rapidity.
For example, it is not unusual that when the principal of a bond comes due, it is re¬nanced by
a new bond issue.
But problems can arise when your ¬rm operates too close to the brink of its ¬nancial ¬‚exibility. Self-ful¬lling Prophecy.
This is more often the case for small and private companies. In this instance, it is quite possible
that you can get either of two self-ful¬lling prophecies (“equilibria”) to occur:

1. Lenders are not worried about the company; the company borrows and operates prof-
itably; lenders see their beliefs con¬rmed and are repaid.

2. Lenders are worried about the company and are unwilling to extend credit; without money,
the company goes bankrupt; lenders see their beliefs con¬rmed that it was wise not to
have extended more credit.

What can you do to avoid the disaster equilibrium? You have a number of options, though all Financial ¬‚exibility
(credit lines, low debt
of them are costly:
ratios, matching in¬‚ows
and out¬‚ows) helps, but
is expensive.
Match Assets and Liabilities You can try to match expected future income to liabilities. For
example, if you are taking out a loan to pay for a new factory, which will come on line
and produce income in three years, you could design the loan to require interest and
sinking fund payments beginning in three years. Matching future in¬‚ows to expected
out¬‚ows is easier to do if your cash ¬‚ows are relatively more predictable and if they
occur sooner”many lenders would be reluctant to provide long-term credit without any
repayment. Moreover, matching in¬‚ows and out¬‚ows makes more sense on a ¬rm-wide
basis, and less sense on a project-by-project basis.

Pay for Flexibility You can pay a bank for an irrevocable credit line. However, although it
is often cheap to get a credit line for sunny times, it is often expensive to get one that
will hold up (not be revoked) in rainy times. Even IBM™s $15 billion credit line, which we
mentioned on Page 628, is subject to various bond covenants”and if IBM were to get into
trouble and needed it, it might no longer be available.
¬le=capdynamics.tex: LP
646 Chapter 25. The Dynamics of Capital Structure and Firm Size.

Hold Liquid Investments You can invest cash in assets that have fairly safe values and allow
for relatively quick and cheap liquidation. Unfortunately, unless your company is a Trea-
sury bond fund, your business is not likely to need such assets as much as it needs the
kinds of assets that are risky and hard to liquidate”for example, your half-constructed
laboratory or half-¬nished R&D would be very di¬cult to resell.

Adjust Capital Structure You can keep a low debt ratio, which allows you to maintain high
interest rate coverage. (That is, your cash ¬‚ows easily cover your debt obligations.) Firms
that have low debt ratios and high interest rate coverage tend to have an easier time
borrowing more cash when they need more. Of course, a low debt ratio may not allow
your ¬rm to take advantage of the tax subsidy due to debt.

When CFOs are surveyed, they state that they pay close attention to their “¬nancial ¬‚exibility””
they care very much about their interest coverage ratios and bond ratings. Such concerns could
be good from a liquidity perspective. With high bond ratings and a lot of cash to pay for interest,
¬rms are unlikely to go bankrupt.
From the manager™s perspective, having more cash is always better than having less cash. But
The drawback to too
much cash. there is also a very dark side to this ¬‚exibility. Access to cash “lying around” tempts managers
to waste money or undertake ventures that they otherwise might not undertake. And investors
may not be all that thrilled with insulation from ¬nancial default”it can lead to satisfaction
with the status quo, as well as ine¬cient investment. After all, management and employees
work harder if they know that the company will go bankrupt if they perform poorly. If the
company has enough of a ¬nancial bu¬er, the ¬rm may remain stuck with poor management
and unmotivated employees.

25·2.D. Market Pressures Towards the Optimal Capital Structure?


A ¬nal interesting question is whether you can just avoid thinking about the optimal capital
The question
structure altogether and simply copy the existing capital structure of similar ¬rms.
The empirical evidence suggests that ¬rms are very slow to counteract what stock market
evidence”why are ¬rms changes do to them, yet stock market changes are exerting tremendously large changes in
not more proactive?
¬rms™ debt-equity ratios. This ¬nding has led to an academic debate (still unresolved) about
what this implies:

1. Are the transaction costs too high to make it worthwhile to change the capital structure?
(If this is true, all our earlier arguments about what should drive capital structure are
fairly unimportant.)

2. Does the optimal capital structure itself change one-to-one with the ¬rm™s market value
(so that no changes are necessary)?

3. Are ¬rms making mistakes by failing to optimize their capital structures?

Anecdote: How Bond Ratings Doomed Trust Preferred Securities And Created Ecaps
In 2005, investment bank Lehman introduced a new debt hybrid called an Ecaps (Enhanced Capital Advantaged
Security). These are securities that have tax-deductible interest payments (which the U.S. IRS disallows for any
perpetual bonds), but that are also very long-term and that allow for interest payment postponement. Therefore,
these bonds are risky, and in many ways more like equity than bonds. This is a very e¬cient tax innovation:
Firms e¬ectively get interest payment tax deductibility on an equity-like security.
Yet an earlier incarnation of such bonds (known as trust-preferred securities) had stalled because Moody™s and
S&P had not determined how to treat these securities. The Ecaps deal succeeded because Moody™s assigned it
into its “Basket D,” which counted Ecaps as 75% equity and 25% debt. Therefore, with the extra cash in¬‚ow and
its modest Moody suggested debt increase, an Ecaps would not likely impact the issuer™s rating negatively.
¬le=capdynamics.tex: RP
Section 25·2. The Managerial Perspective.

If we believed that an outside investor could make money by ¬xing a bad capital structure, as Poor capital structures
can persist.
in a perfect market, then we would also believe that current capital structures are more than
likely fairly close to optimal. Unfortunately, this does not seem to be the case. To “arbitrage” an
incorrect ¬nancing choice, you would have to mount a corporate takeover. The typical takeover
requires a premium of 15 to 30 percent above the current market price, plus another percentage
point to the investment banker. To recapture such a large control premium, rectifying an
incorrect capital structure would have to create large tangible bene¬ts. If it were just a value
increase of 1 to 3 percent per annum, which is not an unreasonably low ¬gure for many ¬rms
that are not too far away from the optimal capital structure, it would probably not be enough.
The situation for inside managers are di¬erent, because they must not pay a control premium. Existing managers can
and should ¬x bad
One to three percent is not an inconsequentially low amount”especially because it is annual
capital structures.
and because it requires almost no e¬ort and investment to ¬x it. For a company like IBM, which
is worth several hundred billion dollars, the value created may be “only” a couple of billion
dollars per year”certainly enough to cover your consulting fee!
The reason why I am bringing up the fact that 1 to 3 percent is usually not big enough to make a Empirical evidence is not
prescriptive, telling you
takeover worthwhile is that whatever capital structure managers may choose is not necessarily
what to do. It is only
the outcome of competitive market pressures where the best capital structure prevails. There descriptive.
can be a whole range of capital ¬nancing arrangements that persist in the economy”including
poor ones”and no one but the managers in charge can ¬x them. Worse, you already know
that managers™ incentives di¬er from those of the shareholders. Managers like free cash ¬‚ow,
¬nancial ¬‚exibility, and control over large ¬rms. Unfortunately, this means that there is only
so much that we (managers and students) can learn from the capital structures of other ¬rms.
Let™s assume that a manager knows what his close comparables are. You already know from
Chapter 10 that comparable may be an oxymoron, because even seemingly similar ¬rms ulti-
mately tend to be very di¬erent upon closer inspection. Let us further assume that there is no
value to being di¬erent from your competitors, which may again not necessarily be true. Can
this manager trust the choices of his peers at his comparables as being optimal? Unfortunately,
no. Given that the high costs of capital structure arbitrage can allow bad capital structures to
persist for a long time, it may be that other managers do the wrong thing. So, you cannot have
blind faith in the “magic of markets” to get the capital structure right. Some modest faith may
be appropriate, though. Knowing what other managers are doing can still be helpful. Just take
this knowledge with a big grain of salt”and realize that other managers, like you, may have
incentives that are not about shareholder value maximization.
Solve Now!
Q 25.3 A $500 million ¬rm is ¬nanced by $250 million in debt and $250 million in equity. If the
market value does not change, describe some actions that managers can undertake to increase
¬rm size to $600 million and change its debt-equity ratio to 5:1.

Q 25.4 A $500 million ¬rm is ¬nanced by $250 million in debt and $250 million in equity. It
issues $150 million in debt, and repurchases $50 million in equity. The market believes the $100
million increase in value will result in wasteful spending by managers, which costs $5 million in
NPV. However, the higher $150 million in new debt will also create $20 million in additional tax
shelter NPV. What is the ¬rm™s new value and new debt-equity ratio?

Q 25.5 What are the two important questions that a CFO acting on behalf of shareholders should

Q 25.6 How can a ¬rm manage cash to avoid running into ¬nancial distress? What are the

Q 25.7 Are existing capital structures necessarily e¬cient?
¬le=capdynamics.tex: LP
648 Chapter 25. The Dynamics of Capital Structure and Firm Size.

25·3. The Capital Issuing Process

Let us now look a little more at the process of capital structure changes, especially issuing.
An outline.
You will learn about some important institutional features of the process, as well as more
information about the available securities corporations can issue.

25·3.A. The Pecking Order (and Financing Pyramid)

A more junior security is paid o¬ in bankruptcy only after the more senior securities are paid
Pecking order causes a
¬nancing pyramid. o¬. Equity is usually the most junior security. There is good evidence that the more junior
the security, the less ¬rms like to obtain funding with it. Firms tend to ¬nance their projects
¬rst with retained earnings, then with debt, and only ¬nally with equity. Put di¬erently, many
¬rms perceive the costs of capital to be lower if the capital comes from internally generated
funds than if it has to be raised by debt and even more so by equity. This characterization
goes beyond these three base mechanisms. It extends to grades within the larger categories,
too. For example, among debt ¬nancings,

• Factored receivables (that is, accounts receivable that are sold o¬) are often safer than
debt, so many ¬rms tend to factor their receivables before they issue more debt.

• Collateralized bonds are more senior and safer than ordinary bonds. Therefore, ¬rms
tend to ¬rst use collateralized bonds before they issue plain bonds.

• Short-term bonds are safer and more senior than long-term bonds. Therefore, ¬rms tend
to ¬rst use short-term debt before they issue long-term debt.

• Bonds with stronger covenants are safer than bonds without covenants. Therefore, ¬rms
¬rst try to issue bonds with strong bond covenants to assure the lenders.

We already mentioned this preference in the previous chapter, calling it a pecking order”
¬nancial markets like and therefore ¬rms tend to issue ¬rst securities that are as safe and as
senior as possible. Only after the costs to issuing such senior debt become very large (e.g., if
the covenants become strangling or if the ¬rm has too much short-term debt) will ¬rms go
to the next instruments. As a result, it is often believed that ¬rms may end up ¬nanced like
a pyramid”a lot of safe (very senior and short-term) debt at the bottom, somewhat less of
more risky debt in the middle, and relatively little equity at the top. This belief is, however,
incorrect if the ¬rm has experienced much equity appreciation, because it could then end up
with a lot more equity than debt in its capital structure, or if the ¬rm™s operating debt decreased
because of external factors. It could also be that many ¬rms do follow this pyramid ¬nancing
arrangement, not because they actively issued debt, but because they incurred many operating
liabilities along the way.
There are a number of deeper explanations for a pecking order preference, the two most promi-
nent of which are:

1. Inside Information We ¬rst learned about the pecking order view in Section 23·5 on Page 606,
where we discussed inside information. The idea was that when a company wants to raise
more ¬nancing, it is in its interest to convince investors that managers and owners are
con¬dent in the ¬rm™s future. Put di¬erently, managers signal their own con¬dence in
the ¬rm by remaining as heavily invested as possible.

2. Agency Considerations This explanation is very closely related to inside information. It
merely states that managers will put the raised money to good use”that it will not just
become free cash ¬‚ow to be wasted. The more junior the security that the ¬rm issues,
the more free cash ¬‚ow managers could waste. Thus, managers who plan to pro¬tably
invest money will not mind as much the more stringent requirements that come with
newly issued senior securities.
¬le=capdynamics.tex: RP
Section 25·3. The Capital Issuing Process.

The inside information and agency theories are the most convincing explanations as to why new
debt issues are greeted more warmly than new equity issues, but they are not exclusive. A more
functional explanation is that any theories in which equity is greeted by the ¬nancial market
with more skepticism than debt can explain a pecking order, in which ¬rms are more reluctant
to issue debt than equity. After all, if the response to the issuance of more junior securities
is more negative, ¬rms prefer the consequently cheaper senior securities. To illustrate, here is
an alternative theory. It could be that investors do not value ¬rms at their present values, but
instead are satiated with shares of a particular ¬rm”the ¬rm issues more and more shares, and
it becomes harder and harder to ¬nd investors. (In economics lingo, the demand for shares is
not perfectly elastic.) This theory could equally well explain a pecking order, in which managers
are reluctant to issue equity and more equity-like instruments, because selling additional shares
costs more. (Interestingly, this theory implies that investors can ¬nd good bets by investing in
neglected stocks.)
Not all ¬rms opt for pure pecking-order behavior and/or pyramid-like ¬nancing arrangements. Not all companies
choose this route.
For example, many leveraged buyout ¬rms such as Kohlberg, Kravis, Roberts (KKR) purchased
many di¬erent companies, but kept each of them in its own insulated shell. KKR™s ¬nancing
scheme had di¬erent costs and bene¬ts from those of most ordinary companies. If one of
KKR™s portfolio companies went bankrupt, it would not bring down KKR™s other companies.
(This arrangement provided good incentives to the management in these companies not to
make mistakes! They would not be rescued by their sibling divisions.) Of course, lenders knew
that they could not lay claim to other KKR assets if the management were to make mistakes.
And they knew that KKR was not con¬dent enough in the quality of a particular acquisition to
pledge KKR™s remaining assets to the lenders. If KKR had followed the intuition of the adverse
selection/pecking order, they would have been willing to stake all their projects as collateral
when they borrowed money for a particular portfolio company. Because they failed to do so,
lenders demanded signi¬cantly higher interest rates from KKR™s individual portfolio companies
than they would otherwise have demanded. And KKR had to pay the price in a higher total cost
of capital than they otherwise would have had to.

25·3.B. Debt and Debt-Hybrid O¬erings

We now turn to ¬rms™ debt issuing activities. Debt o¬erings are much more frequent than equity An outline”debt is more
o¬erings. In fact, except in the context of acquisitions where both equity and debt o¬erings are
common, large, publicly traded ¬rms tend to ¬nance almost all their projects through either
retained earnings or debt o¬erings. Debt o¬erings are bread-and-butter for both ¬rms and
investment banks.

Fair Pricing of Bond Features
We have already discussed the many features of bonds (such as seniority, security, covenants, Contract provisions are
“priced in.”
collateral, conversion, callability, puttability, maturity, duration, ¬xed-vs.-¬‚oating). IBM™s debt
structure, described in Tables 24.2 and 24.3, is a good example of the variety of debt claims a
¬rm may have outstanding. For most bond features, the basic ¬nance mantra holds: You get
what you pay for. For example, if you give bond buyers more rights (e.g., a conversion feature),
you get to pay a lower interest rate. If you want to keep more rights (e.g., retain a call feature),
you must pay a higher interest rate. Despite some empirical behavioral ¬nance evidence to
the contrary, it seems unlikely that managers can guess what features the market generally
overvalues or undervalues, and of course whether interest rates will go up or down. But fair
pricing does not mean that you cannot add value by choosing debt securities that employ the
features that are most appropriate to your own ¬rm. Consider a bond feature that says that
all factories will be permanently closed if the NFC team wins the Superbowl. In a competitive
market, you will get a fair price for this bond and any other securities that you might issue,
but this is not a great security to issue if you want to maximize market value. The point is
that you should o¬er bonds that have features that are well-suited to your company. But if you
stay within the limits of ordinary and frequent bond features (say, choosing a convertibility or
callability feature), it is often true that it will matter only modestly which exact features your
¬le=capdynamics.tex: LP
650 Chapter 25. The Dynamics of Capital Structure and Firm Size.

bonds are o¬ering.

Assembling the Building Blocks into a Real O¬ering
So far, we have pretty much taken the bu¬et approach to bond features”we have discussed
Issues are complex
enough to need an each one by itself. Let™s now have a full-course dinner. How do large publicly traded corpora-
investment banker as
tions really borrow money? The most common way for many mid- to large-cap companies to
borrow is to obtain a bank credit facility and issue multiple bonds (“term debt”) at the same
time. The ¬nancing package consists of two parts, the revolver and the term debt:

The revolver (i.e., a revolving credit line) is a line of credit on which the company can borrow
and repay and borrow again until a termination date/maturity. The bank o¬ering the
revolving credit line also receives a fee for the unused/undrawn portion of the revolver.
The term debt is structured in one or more tranches (French for “slices”). The principal pay-
ment schedule and maturity date are di¬erent for each of the tranches. Tranche A would
begin to amortize right away and would have the shortest term to maturity. The Tranche B
term loan would amortize and mature after the Tranche A term loan but before the
Tranche C term loan, and so on.

The revolver and Tranche A loan usually carry the same interest rate spread over LIBOR and
are marketed as a package. The Tranche B and C lenders receive wider spreads over LIBOR to
compensate creditors for the added credit risk of having a longer term loan to maturity.
Who sells these instruments? If the bond issue is large, a “lead” investment banker (“under-
writer”) syndicates a large part of the corporate bond to other investment banks to make it
easier to place the bond. (Lead underwriters are often the big money banks, such as J.P. Mor-
gan Chase and Citibank. We will discuss investment banks in Chapter 27.) The deal itself is
brought to the capital markets with proposed pricing by the syndicate lead and is priced at
whatever price (interest rate) clears the market.
Who are the investors in these multiple loan instruments (all issued simultaneously)? Because
institutions and mutual funds are not set up to provide revolving credit, the “pro rata” revolver
piece and Tranche A loan are often purchased by commercial banks. The market for subsequent
tranches of term debt is more liquid, and these bonds are typically purchased by mutual funds,
commercial banks, hedge funds, etc.
Smaller companies usually borrow in simpler ways. They often have a relationship with either
Smaller Companies.
a smaller syndicate of commercial banks, or perhaps a regional bank in the case of a very
small company. The structure would in all likelihood be less complex”a revolver and only one
tranche of term debt, or just a revolver. In terms of pricing, their bond must o¬er premium
pricing to compensate the lenders for the added credit risk of lending to a small company and
for holding a less liquid ¬nancial claim. (The price is negotiated between the borrower and

Post Placement and Bond Liquidity
As with all securities, issuers can raise ¬nancing at lower costs if they can give potential in-
Bonds usually are
illiquid”and, when they vestors more information and the ability to liquidate their investment quickly. You already
do trade, do so
know that equity securities are usually bought and sold on stock exchanges after the original
o¬ering. The two most important exchanges in the United States are Nasdaq and the NYSE.
Bonds, on the other hand, often do not trade on any exchange (such as the New York Bond
Exchange). And when they do trade, the markets tend to be not very liquid. (The bond trading
volume on exchanges is very low.) Instead, most bonds are traded over-the-counter, that is, by
large investors who call up individual investment banks™ desks. The transaction price is usu-
ally not disclosed in such cases, and trading is fairly rare. Because the vast majority of bond
transactions take place between brokers rather than on an exchange, accurate bond prices are
di¬cult to come by. Thus, individual investors are typically better o¬ staying away from pur-
chasing individual bonds, unless they wish to be taken advantage of. A better alternative for
individual investors would be to purchase a good mutual fund that just holds bonds.
¬le=capdynamics.tex: RP
Section 25·3. The Capital Issuing Process.

Coercive Bond Exchange O¬ers
Most bonds include contract provisions by which covenants can be changed. These provisions Most of the time,
covenants are ¬rm.
are usually di¬cult to change, except in ¬nancial distress. So, for the most part, ¬rms must
live with whatever covenants they write upfront.
But there is one mechanism that sometimes allows creditors to take advantage of public bond- But there is one
occasional exception,
holders and that you should be aware of: the exchange o¬er. These days, they are rare, because
which appears if
creditors try to protect themselves against such o¬ers. Still, the basics of the mechanism is creditors are
worth knowing. “underwater.”

Consider a ¬rm worth $500, which had earlier sold one type of bond with a face value of $1,000 How to “swindle” the
to 100 creditors. Each bond is a claim on $10, and it is now really worth only $5. How can
managers reduce the face value of the claim, so that an increase of less than $500 would allow
the equity to be back in the money again? The answer is an exchange o¬er. For example, if
you o¬er each creditor a higher-seniority (or shorter term) bond for only a claim of $6 (a total
of $600), it would not be, collectively, a good exchange for them. But consider what is in the
interest of each creditor.

• If no other creditor accepts the exchange o¬er, then an unexchanged $10 bond is worth
only $5. If one creditor accepts the exchange bond, it is paid ¬rst, so its value increases
from $5 to $6.

• If the remaining 99 creditors all accept the exchange o¬er, then an unexchanged $10 bond
would be worth nothing. The new bonds would collectively claim 99 · $6 = $594 of the
¬rm”and with only $500 in value, nothing would be left for an original, unexchanged,
and thus lower-priority bond.

It is in the interest of every bondholder to participate, but that means they will collectively end
up worse o¬. Thus, the bond exchange o¬er works only if the ¬rm can play o¬ its creditors
against one another”it does not work if one single creditor (a bank) holds the entire bond issue.
To eliminate such coercive bond exchange o¬ers, many bond covenants now require ¬rms to
¬rst obtain approval by majority or super-majority vote before a bond can be exchanged or a
covenant be waived. In this case, every bondholder would vote against the exchange o¬er, and
thereby come out better o¬.

25·3.C. Seasoned Equity O¬erings

Most publicly traded shares appear on an exchange in the context of a public equity o¬ering. Seasoned equity
offerings are rare.
An initial public o¬ering is the ¬rst sale of shares to the public. A seasoned equity o¬ering
is the sale of shares in an already publicly traded company. Seasoned equity o¬erings are
rare events for large publicly traded corporations, except in connection with M&A activity. In
contrast to bonds, liquidity is not a big problem for after-market stock investors. Over 10,000
large U.S. ¬rms now have their common stock traded on a major public stock exchange, such as
Nasdaq or the NYSE. There, any investor can easily purchase and sell shares, and closing prices
for the previous day can readily be found in most newspapers. Not all shares are ¬rst issued
and sold on an exchange. Some shares may simply be granted to employees or managers, and
not necessarily from treasury stock, which is the shares that the company itself is still holding,
and into which repurchased shares usually go.
The institutional process required to sell new shares in a public o¬ering is lengthy and unwieldy. How to avoid the SEC
(For initial public o¬erings, it is an outright ordeal.) Fortunately, ¬rms with fewer than 100
investors that do not try to sell their claims to the public are not (or are at least less) regulated
by the SEC, and thus can avoid the process. (In a famous incident, Google ran into the constraint
that it had more than 100 entities owning shares, so it had no choice but to go public, even
though it did not need external funds.) Many smaller companies and hedge funds would simply
be overwhelmed by the costs of navigating the SEC process.
¬le=capdynamics.tex: LP
652 Chapter 25. The Dynamics of Capital Structure and Firm Size.

Public ¬rms can issue seasoned equity through various mechanisms. The three most important
Choices of Issuing.
ones are:

1. Standard Issue For example, a ¬rm with 50 million shares representing $400 million in
Ideally, old shareholders
would come out the outstanding equity (i.e., $8/share) may announce that its board of directors has approved
the issuance and sale of another 10 million shares in 3 months. The shares are to be
sold into the market at the then-prevailing stock price three months later. If the stock
price will be $10/share at the time of the o¬ering, the ¬rm value will be $500 million just
before the o¬ering and $600 million just after the o¬ering. So, both immediately before
and after the o¬ering, each old shareholder will still own a claim of $10/share.

2. Shelf O¬ering (Rule 415 O¬ering) For new equity shares registered with the SEC under Rule
Shelf offerings can be
“lazy.” 415, the ¬rm does not set one ¬rm date at which the shares are to be sold into the market.
Instead, the ¬rm can sell them over a period of up to two years, at its own discretion and
without further announcements. This is similar to the way that companies sell debt notes
(Page 625), that is, on demand and o¬ the shelf.

3. Rights O¬erings Yet another way to sell new equity shares is a rights o¬ering. These are
The mechanics.
rare in the United States, but popular in some other countries (e.g., the United Kingdom).
Instead of issuing new shares to anyone willing to purchase them, the company grants
existing shareholders the right to purchase one additional share of equity at $2 share. If all
50 million shareholders participate, the company will raise $100 million. Each shareholder
will own two shares, so there will now be 100 million shares to represent $600 million in
assets. Each share will be worth $6/share, and each old investor will have invested $12
for two shares.
So far, there is no di¬erence between the rights o¬ering and the plain o¬ering: both
Rights Offerings force
participation. facilitate the raising of $100 million without loss for existing shareholders. However,
what happens to a shareholder who does not participate? This shareholder will then own
one share, for which she will have paid $10, and which will only be worth $6. This non-
participating shareholder will have been expropriated. Therefore, rights o¬erings allow
the ¬rm to e¬ectively force existing shareholders to participate in the o¬ering.

Like bond o¬erings, equity o¬erings are usually orchestrated by an underwriter. We shall look
at underwriters in more detail in Chapter 27.

Side Note: There is also a distinction between primary shares and secondary shares. These are confusing
names, because they do not describe the distinction between an initial public o¬ering and a seasoned o¬ering.
Instead, primary shares are shares that are newly minted and sold by the ¬rm itself, in which case the proceeds
go to the ¬rm itself. (These are really the kinds of o¬erings that we just discussed.) Secondary shares are
shares that are sold by an investor in the ¬rm (e.g., by the founder), in which case the company does not receive
the issue proceeds. Secondary o¬erings are de facto insider sales, so they are also often smaller than primary
o¬erings. But they are usually greeted especially negatively by the market: an owner who wants to abandon ship
and sell out is not good news. Because our book focuses on the ¬rm™s capital structure, we are concentrating
on primary o¬erings.

25·3.D. Initial Public O¬erings

In contrast to a seasoned equity o¬ering, an initial public o¬ering is the ¬rst public sale of
IPOs are special”a lot
riskier and with many shares. There are some features that are unique to IPOs:
separate regulations.

1. There is no established price, so it is considerably more di¬cult and risky to place IPO
shares. Without a public price, we cannot measure how the market responds to the an-
nouncement of the IPO. (Also, the diversi¬cation bene¬ts for the current owners are usu-
ally much larger than they are in seasoned equity o¬erings.)

2. There are many unusual regulations governing the issuance of IPOs. For example, issuer
and underwriter are liable not just for false statements, but even for “material omissions.”

3. Until recently, shares had to be sold at a ¬xed price that could not be adjusted upward if
demand for shares was strong, or downward if demand for shares was weak. Most IPOs
¬le=capdynamics.tex: RP
Section 25·3. The Capital Issuing Process.

are still conducted this way, although it is now possible for strong issuers to auction their
shares into the public markets. (The 2004 IPO of Google was the most prominent auction.)

In a typical IPO, the issuer must provide audited ¬nancials for the most recent three years. Thus, Some of the process.
unless the ¬rm is so new that it has no recent history, or unless the ¬rm has carefully planned
its IPO years ahead, many ¬rms must go back and create audited ¬nancials for activities that
happened long ago. Similarly, ¬rms often have a lot of other housecleaning to do”folding in
or laying out subsidiaries, untangling relationships between the private owners and the ¬rm,
and so on. The real IPO process starts when the ¬rms selects an underwriter (usually after
presentations by 3-5 investment bankers). It is the underwriter who orchestrates the o¬ering.
Together with the auditor and legal counsel, the underwriter and the ¬rm create a preliminary
o¬ering prospectus and ¬le it with the SEC. They then give a set of “roadshow” presentations
to solicit interest among potential investors. But neither is allowed to make statements beyond
those in the preliminary prospectus. It also does not usually include one ¬xed price, but only
an estimate (a price range). Finally, the underwriter is not allowed to take ¬rm buy orders, but
can informally collect a list of interested parties.
Usually within 48 hours after the SEC approves the prospectus, the o¬ering goes live. The ¬nal IPO Underpricing.
o¬er price is set on the morning of the o¬ering. Remarkably, IPOs are usually priced to create
excess demand among investors, so shares become rationed. The average IPO experiences a
jump of about 10% in one day (not annualized!), called IPO underpricing. In the 1999“2000
bubble, however, average underpricing reached as high as 65% again in just one day. There are
a number of theories that help explain the continued presence of IPO underpricing.

• Winner™s Curse If uninformed investors ask for allocations, they will disproportionately be
stuck with shares in the hard-to-sell o¬erings. For example, if half the o¬erings earn
+10% and are oversubscribed by a factor of 2, and half the o¬erings earn “10% and are
undersubscribed, it would be 0% on average, but our uninformed investor would receive
an allocation of only half as many shares in the +10% o¬ering as in the “10% o¬ering, so
the average rate of return would be
expected expected
share share
allocation allocation
50% · 0.5 · (+10%) + 50% · 1.0 · (+10%) = ’2.5% .
%underpriced %overpriced overpricing
o¬erings o¬erings

So, if shares on average earn a 0% rate of return, uninformed investors should not partici-
pate, because their return will be less than 0%. To keep them in the market, underwriters
underprice IPOs.

• Information Extraction Underwriters need to pay investors for their opinions. Without un-
derpricing as compensation, all investors would tell the underwriter that they believe that
the o¬ering is not worthwhile, hoping for the bargain of lower pricing. With underpricing
as the currency of compensation, underwriters can pay investors to tell them truthfully
their otherwise private reservation price. They must then reward enthusiastic investors
with more (and just mildly) underpriced shares. This strategy can actually maximize the
o¬ering proceeds.

• Good Taste in Investors™ Mouths Underwriters want to create goodwill among investors to
make it easier to place subsequent o¬erings. A bad or fraudulent issuer would not want
to play this game, because the fraud would likely collapse before the goodwill pays o¬.

• Cascading Demand Investors are eying one another, so that o¬erings end up either a tremen-
dous success or an utter failure. To avoid the latter, underwriters prefer to ensure success
by underpricing.

• Agency Con¬‚ict (Underwriter Selling E¬ort) It is more e¬cient for the issuer to make sell-
ing easier by underpricing than it is to price the o¬ering correctly and try to ascertain
whether underwriters are doing their best to place the o¬ering.
¬le=capdynamics.tex: LP
654 Chapter 25. The Dynamics of Capital Structure and Firm Size.

• Agency Con¬‚ict (Additional Underwriter Compensation) Although it is not in the interest
of the issuer, underwriters use IPO underpricing as “currency” to reward their best bro-
kerage customers. This requires that it is the underwriter who is in the driver seat, not
the issuer.

Finally, after the ¬rm is publicly trading, the underwriter often tries to “stabilize” the market
and promote the ¬rm as well as reasonable trading volume in the after-market. Indeed, for
small ¬rms, the underwriter is usually also the Nasdaq market maker, providing investors with
the appropriate liquidity.
Underpricing is just one among a number of interesting phenomena for IPO ¬rms. We do not
Other interesting IPO
phenomena. yet fully understand all of them, but here is an interesting selection of ¬ndings about IPOs:

1. On average, IPO ¬rms drastically underperform similar benchmark ¬rms, beginning about
6 months after the IPO and lasting for about three to ¬ve years. (A conservative estimate
is a risk-adjusted underperformance of about 5% per annum relative to the overall stock
market.) However, it is not only the IPO ¬rms themselves that seem to perform poorly
after the IPO, but also ¬rms that are similarly sized and in the same industry. No one really
knows why. We do know that this downward drift is considerably stronger for ¬rms that
are very aggressive in the reporting of their ¬nancials at the IPO.
Who would be foolish enough to hold onto IPO shares for more than the ¬rst 6 months? Be-
cause academic researchers cannot ¬nd out where equity shares are located (most stock
holdings are con¬dential), we cannot fully study this phenomenon. The “word on the


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