Insider Holdings and Leverage

Closely held firms (where managers and insiders hold a substantial portion of the outstanding stock) are less likely to increase leverage quickly than firms with widely dispersed stockholdings.

a. True b. False Explain.

2 Palepu (1986) notes that one of the variables that seems to predict a takeover is a low debt ratio, in conjunction with poor operating performance.

Illustration 9.1: Debt Capacity and Takeovers

The Disney acquisition of Capital Cities in 1996, although a friendly acquisition, illustrates some of advantages to the acquiring firm of acquiring an under levered firm. At the time of the acquisition, Capital Cities had $ 657 million in outstanding debt and 154.06 million shares outstanding, trading at $ 100 per share. Its market value debt ratio was only 4.07%. With a beta of 0.95, a borrowing rate of 7.70%, and a corporate tax rate of 43.50%, this yielded a cost of capital of 11.90%. (The treasury bond rate at the time of the analysis was 7%) Cost of Capital

= Cost of Equity(Equity/(Debt+ Equity)+Cost of Debt(Debt/(Debt + Equity) = 12.23% (15,406/(15,406+657)) + 7.70% (1-.435) (657/(15,406+657)) = 11.90%

Table 9.1 summarizes the costs of equity, debt, and capital, as well as the estimated firm values and stock prices at different debt ratios for Capital Cities:

Table 9.1: Costs of Financing, Firm Value and Debt Ratios: Capital Cities

Debt Ratio


Cost of Equity

Interest Coverage Ratio

Bond Rating

Interest Rate

Cost of Debt

Cost of Capital

Firm Value

Stock Price


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