Ways of changing the financing mix

There are four basic paths available to a firm that wants to change its financing mix. One is to change the current financing mix, using new equity to retire debt or new debt to reduce equity; this is called recapitalization. The second path is to sell assets and use the proceeds to pay off debt, if the objective is to reduce the debt ratio, or to reduce equity, if the objective is to increase the debt ratio. The third is to use a disproportionately high debt or equity ratio, relative to the firm's current ratios, to finance new investments over time. The value of the firm increases, but the debt ratio will also be changed in the process. The fourth option is to change the proportion of earnings that a firm returns to its stockholders in the form of dividends or by buying back stock. As this proportion changes, the debt ratio will also change over time.

Recapitalization

The simplest and often the quickest way to change a firm's financial mix is to change the way existing investments are financed. Thus, an underlevered firm can increase its debt ratio by borrowing money and buying back stock or replacing equity with debt of equal market value.

• Borrowing money and buying back stock (or paying a large dividend) increases the debt ratio because the borrowing increases the debt, while the equity repurchase or dividend payment concurrently reduces the equity. Many companies have used this approach to increase leverage quickly, largely in response to takeover attempts. For example, in 1985, to

Debt-for-Equity Swaps: This is a voluntary exchange of outstanding equity for debt of equal market value.

stave off a hostile takeover3, Atlantic Richfield borrowed $ 4 billion and repurchased stock to increase its debt to capital ratio from 12% to 34%. • In a debt-for-equity swap, a firm replaces equity with debt of equivalent market value by swapping the two securities. Here again, the simultaneous increase in debt and the decrease in equity causes the debt ratio to increase substantially. In many cases, firms offer equity investors a combination of cash and debt in lieu of equity. In 1986, for example, Owens Corning gave its stockholders $ 52 in cash and debt, with a face value of $ 35, for each outstanding share, thereby increasing its debt and reducing equity.

In each of these cases, the firm may be restricted by bond covenants that explicitly prohibit these actions or impose large penalties on the firm. The firm will have to weigh these restrictions against the benefits of the higher leverage and the increased value that flows from it. A recapitalization designed to increase the debt ratio substantially is called a leveraged recapitalization, and many of these recapitalizations are motivated by a desire to prevent a hostile takeover4.

Though it is far less common, firms that want to lower their debt ratios can adopt a similar strategy. An overlevered firm can attempt to renegotiate debt agreements, and try to convince some of the lenders to take an equity stake in the firm in lieu of some or all of their debt in the firm. It can also try to get lenders to offer more generous terms, including longer maturities and lower interest rates. Finally, the firm can issue new equity and use it pay off some of the outstanding debt. The best bargaining chip such a firm possesses is the possibility of default, since default creates substantial losses for lenders. In the late 1980s, for example, many U.S. banks were forced to trade in their Latin American debt for equity stakes or receive little or nothing on their loans.

Divestiture and Use of Proceeds

Firms can also change their debt ratios by selling assets and using the cash they receive from the divestiture to reduce debt or equity. Thus, an underlevered firm can sell some of its assets and use the proceeds to repurchase stock or pay a large dividend. While

3 The stock buyback increased the stock price and took away a significant rationale for the acquisition.

this action reduces the equity outstanding at the firm, it will increase the debt ratio of the firm only if the firm already has some debt outstanding. An overlevered firm may choose to sell assets and use the proceeds to retire some of the outstanding debt and reduce its debt ratio.

If a firm chooses this path, the choice of which assets to divest is a critical one. Firms usually want to divest themselves of investments that are earning less than their required returns, but that cannot be the overriding consideration in this decision. The key question is whether there are potential buyers for the asset who are willing to pay fair value or more for it, where the fair value measures how much the asset is worth to the firm, based upon its expected cash flows.

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