Question

The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy of the company. The board discussed the optimal capital structure of 60 percent debt and 40 percent equity and the likely effect of the capital structure on the company’s weighted average cost of capital (WACC) and the firm value. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Therefore, the debt ratio of 60 percent was considered acceptable. However, Gregg, the CFO of the company, stressed that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter the profit of the company. He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Gregg continued to explain that if the company files for bankruptcy there are direct and indirect costs that Baldwin must incur.

Mr. Milosvoski, a board member suggested that there are ways to reduce the cost of debt by hiring an expert to handle the company’s debt agreements between the shareholders and bondholders. He stated that protective covenants are incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. He mentioned negative covenant and a positive covenant as types of protective covenants the company should take seriously.

John Miller, another board member stated that one reason bankruptcy costs are so high is that different creditors and their lawyers contend with each other. He suggested that if debt can be consolidated, or if bondholders can be allowed to purchase stock of the company bankruptcy cost will be reduced. In this way, stockholders and debtholders are not pitted against each other because they are not separate entities. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money.

The employee representative on the board, Ms. Johnson used the free cash flow hypothesis to state that firms with high free cash flow are very likely to undertake more wasteful activity which has a serious implication for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to her, an increase in dividends should benefit the stockholders by reducing the ability of corporate managers to pursue wasteful activities. She continued that since interest and principal also leave the firm, debt can reduce free cash flow and wasteful spending. But because corporate managers are not legally obligated to pay dividends, she suggested that debt of the company be increased.

Philip Suzuki, director of Public Relations and a board member was of the view that determining optimal debt-equity ratio is not an easy task and varies across industries so Baldwin should follow the rules of the pecking-order theory when financing capital projects. No agreement was reached on the company’s capital structure, but the CEO and Gregg believed that the 60-40 debt-equity capital structure will minimize the cost of capital and improve the firm value.

The board is retaining you as the financial consultant to assist with the company’s capital structure and dividend payout decisions. The Chairman of the board wants you to address the following questions:

1. List 5 reasons to support Ms. Johnson’s free cash flow hypothesis claim that debt of Baldwin Inc. be increased. The reasons you give should focus on advantages of debt that can convince the board to increase the debt-to equity ratio of the company.

The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy of the company. The board discussed the optimal capital structure of 60 percent debt and 40 percent equity and the likely effect of the capital structure on the company’s weighted average cost of capital (WACC) and the firm value. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Therefore, the debt ratio of 60 percent was considered acceptable. However, Gregg, the CFO of the company, stressed that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter the profit of the company. He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Gregg continued to explain that if the company files for bankruptcy there are direct and indirect costs that Baldwin must incur.

Mr. Milosvoski, a board member suggested that there are ways to reduce the cost of debt by hiring an expert to handle the company’s debt agreements between the shareholders and bondholders. He stated that protective covenants are incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. He mentioned negative covenant and a positive covenant as types of protective covenants the company should take seriously.

John Miller, another board member stated that one reason bankruptcy costs are so high is that different creditors and their lawyers contend with each other. He suggested that if debt can be consolidated, or if bondholders can be allowed to purchase stock of the company bankruptcy cost will be reduced. In this way, stockholders and debtholders are not pitted against each other because they are not separate entities. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money.

The employee representative on the board, Ms. Johnson used the free cash flow hypothesis to state that firms with high free cash flow are very likely to undertake more wasteful activity which has a serious implication for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to her, an increase in dividends should benefit the stockholders by reducing the ability of corporate managers to pursue wasteful activities. She continued that since interest and principal also leave the firm, debt can reduce free cash flow and wasteful spending. But because corporate managers are not legally obligated to pay dividends, she suggested that debt of the company be increased.

Philip Suzuki, director of Public Relations and a board member was of the view that determining optimal debt-equity ratio is not an easy task and varies across industries so Baldwin should follow the rules of the pecking-order theory when financing capital projects. No agreement was reached on the company’s capital structure, but the CEO and Gregg believed that the 60-40 debt-equity capital structure will minimize the cost of capital and improve the firm value.

The board is retaining you as the financial consultant to assist with the company’s capital structure and dividend payout decisions. The Chairman of the board wants you to address the following questions:

1. List 5 reasons to support Ms. Johnson’s free cash flow hypothesis claim that debt of Baldwin Inc. be increased. The reasons you give should focus on advantages of debt that can convince the board to increase the debt-to equity ratio of the company, and state 5 examples of direct and indirect costs associated with bankruptcy that Gregg stated in his presentation to the board.

Answer 1

Before listing 5 reasons to support Ms. Johnson's free cash flow hypothesis claim the debt of Baldwin Inc to be increased. It is important to understand some important terminology i.e. Debt financing and equity financing.

Debt financing - Debt financing means borrowing a sum from the lender and repaying back with interest.

Equity financing- Equity financing means selling the percentage of ownership of the business to investors to raise the fund.

Advantage of debt

1. Business ownership is not diluted.

By using debt financing the company retains the control to implement business strategies. The voting right is not passed if financing is done by debt.

2. Easy Administration

Issue of stock and managing it is a complex process because it has regulatory requirements. whereas debt financing is less expensive in the long run because of not distributing profits.

3. Tax-deductible

Interest is a tax-deductible it lowers the effective cost of debt. The principal and interest on the debt are subtracted from business income and this tax is saved.

4. Create and establish business credit

Business credit is important if a company seeks low cost of long term debt. when a company creates good credit the company can avail long term loans on low-interest rates and dependence on the personal credit, usually a high rate of interest is charged is reduced.

5. Debt can enhance growth

Long term debt is used to acquire machinery, increasing marketing activities, hiring new employees. Low cost, long term debt maintain desired working capital and it enhances the smooth operation and profit throughout the year.

PART B

5 examples of direct and indirect costs associated with bankruptcy that Gregg stated in his presentation to the board.

Direct cost

Direct cost is the cost in which cash outflows from the company.

Examples

1.Legal cost

2. Accounting cost

3.Loss of fees paid to Liquidators and Administrators

4. Loss of tax benefits.

5. Loss arising from the sale of assets at a distressed price.

Indirect cost

Indirect cost is the cost that does not involve cash outflow but makes the survival of the company difficult.

1.Loss of employees.

2. Loss of creditors.

3.Loss of trust in the eyes of customers.

4. Loss of Intangible assets.

5. Loss of Market Share.