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. Give two examples each of positive covenant and negative covenant as stated by Mr. Milosvoski in his protective covenant explanation, and explain the rules of pecking-order theory of capital structure as suggested to the board members by Mr. Suzuki, the director of Public Relations.

Answer 1

A positive covenant is what the company is allowed to do post issuance. Mostly, they are administative in nature and do not limit the operations of the firm

A negative convenant is what a compnay can not do post issuance. They are restrictive in nature.

Example of positive covenants:

• The compnay must obtain lender's permission befoe incurring a capital expenditure.
• The compnay must maintain a current ratio in excess of 1.50 during the life of the loan.

Examples of negative convenants:

• The firm shall not pay any dividend to any of its shareholders including promoters till the time the loan is outstanding.
• The firm shall not increase the indebtedness beyond $ 200 million, till the time the loan is outstanding.

The rules of pecking-order theory of capital structure:

• The firm should use internal accrual as its first source of finance
• Only when internal accruals hae been used up, the firms should next resort to external debt as a source of finance.
• And finally, as a last resort, the firm should raise external equity as a source of finance