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

Beta

Cost of Equity

Interest Coverage Ratio

Bond Rating

Interest Rate

Cost of Debt

Cost of Capital

Firm Value

Stock Price

0.00%

Debt Destroyer

Debt Destroyer

Free Yourself From Debt Forever. Discover How An Underpaid Worker Freed Himself From His Unimaginable Debt And Carved His Way To Financial Freedom. Finally You Can Fully Equip Yourself With These “Must Have” Tools For Busting Debt And Live A Life Without Having To Worry About Debt Collectors.

Get My Free Ebook


Post a comment