Capital Structure
ARTICLE 2 You have more capital than you think
Value-adding risk = associated with positive-net-present-value activities in which the company
has a competitive advantage. All other risks can be hedged or insured against through the
financial market.
Potential of creating shareholder value through financial engineering: equity capital used as
cushion strips out the non-value-adding (passive) risk and the rest can be used to finance more
value-adding assets.
Hedging options are especially important to private companies with no access to public equity
markets and thus cannot easily increase their capital by issuing shares. Smart financial
engineering frees up equity capital for strategic investments, allowing a company to finance
more value-adding growth for the same amount of equity. It leads to no change in the level of
risk a company bears, just a change in the risk’s nature.
Companies think of competitive advantages as assets and capabilities, but they should focus
on value-adding activities and assets. This is also true for risks.
The cost of equity is not wholly determined by the risks of the assets and activities that the
equity helps to finance, because it also carries a tax burden and considerable agency costs
and high transaction costs for issuance.
When value-adding risks are identified the company can work out how much equity capital it
can eliminate by hedging, selling, or insuring its passive risks.
The equity capital requirement is typically based on the VaR, where the most sophisticated
tools can be found in the securities and banking industries. Applying a VaR-tool involves
estimating the volatility of the value of the company’s business portfolio and calculating from
that the maximum potential loss in asset value the company the company is likely to sustain
over a given time period with a given confidence level. The equity capital requirement is mostly
a multiple of the VaR. The required equity cushion is determined by the risk of the company.
The WACC doesn’t affect the needed amount of equity capital, since its determined by the
amount of systemic risk, measured by the sensitivity of the company’s asset value to changes
in overall equity market prices.
With customer loans there are two types of risk involved: interest rate risk and credit risk.
Interest rate risk can be hedged by swaps, leading to the possibility for banks to take on more
value-adding risk. Nowadays, the swap market is a highly liquid, deep, and safe market to
operate in.
The credit default swap largely frees banks from credit limits due to credit risk of individual
borrowers. The CDS resembled an insurance policy in that a bank will pay the equivalent of a
premium to the swap counterparty in return for the right to a full payment of a loan if a borrower
defaults. The bank thus has to pay for the contract, which represents an opportunity cost. But
the cost of the insurance provided by the swap is considerably lower than the cost of providing
the same insurance through equity capital.
Equity swap = enables you to exchange the returns on your stock-market-invested pension
assets for a fixed-rate, long-duration return that can be tailored to you pension liabilities
(=remove specific market-related risks). But they can also be used to strip away the market-
related risks of the operating business itself.
Most corporations bear substantial amounts of passive risk, some of which is imposed upon
them by decisions made when cost-effective means for shedding these risks were not
available, and some of which is an inevitable consequence of their industries’ competitive
dynamics. This leads to significant amounts of equity tied up as a cushion for the risk mismatch
,between their pension assets and liabilities. All these passive risks can be either capped or
outright eliminated and removed from the risk balance sheet by hedging, selling, or insuring.
Corporate Debt Policy
ARTICLE 3 New Framework for Corporate Debt Policy
For many companies the debt-capacity decision is of critical importance because of its potential
impact on margins of profitability and on solvency. The debt decision is balancing of higher
prospective income to the shareholders against greater chance of loss. When the work “risk” is
applied to debt, it may refer to the chance of running out of cash, so that legal contracts are
defaulted, bankruptcy occurs, and normal operations cease. Any addition to mandatory cash
outflows resulting from new debt must increase this risk. Cash inadequacy = whole family of
problems involving the inability to make cash payments for any purpose important to the long-
term financial health of the business; cash-insolvency is the extreme cash of cash inadequacy.
Mostly, debt capacity is drawn from one or more of several sources:
Seek the counsel of institutional landers or financial intermediaries (such as investment
bankers)
See what comparable companies are doing in this area of financial management
Follow the practices of the past
Refer to that very elusive authority called ‘general practice’, ‘industry practice,
‘common knowledge’, or ‘financial folklore’
In assessing the risks of running out of cash because of excessive fixed cash obligations, the
special circumstances of the individual firm are the primary data the analyst has to work with.
Management obviously has advantages over outsiders because it has free and full access to it,
the time and incentive to examine it thoroughly, and a personal stake in making sensible
judgements about what it observes. Next to that, the measurement of risk is only one
dimension of the debt-capacity decision. In a free enterprise society, the assumption of risk is a
voluntary activity, and no one can properly define the level of risk, which another should be
willing to bear. The decision to limit debt to a certain percentage of the capital structure reflects
both the magnitude of the risk involved in servicing that amount of debt and the wiliness of
those who bear this risk to accept the hazards involved.
Many companies rely heavily on other people’s advice in deciding how far to go in using other
people’s money, because there is:
A misunderstanding of the nature of the problem and a failure to separate the
subjective from the objective elements
The inherent complexity of the objective side = the measurement of risk
The serious inadequacy of conventional debt-capacity decision rules as a framework
for independent appraisal
In practice, an internally generated debt-capacity decision is often based almost entirely on the
management’s general attitude toward this kind of problem without regard for how much risk is
actually involved and what the potential rewards and penalties from bearing this risk are.
Debt capacity is most commonly described in terms of the balance sheet relationship between
long-term debt and the total of all long-term sources, viz., as some percentage of capitalization.
The alternative form in which to express the limits of long-term borrowing is in terms of income
statement data: earnings coverage ratio – the ratio of net income available for debt servicing to
the total amount of annual interest + sinking fund charges. When a company wants to
, formulate its own debt standard as a percentage of capitalization, the standard must be
expressed in terms of data which can be related to the magnitude of the risk in such a way that
changes in the ratio can be translated into changes in the risk of cash inadequacy, and vice
versa. However, the balance sheet on which the standard is based provides little direct
evidence on the question of cash adequacy may be highly unreliable and misleading. There
are some obvious key weaknesses of relating the principal amount of long-term debt to
historical asset values as a way of looking at the chances of running out of cash:
There is a wide variation in the relation between the principal of debt and the annual
obligation for cash payments under the debt contract.
As loans are repaid by partial annual payments, the principal amount declines and the
percent of capitalization ratio improves, but the annual cash drain for repayment
remains the same until maturity is reached.
There may be substantial changes in asset values, and as a consequence, changes in
the percent of capitalization ratio that have no bearing on the capacity to meet fixed
cash drains.
Certain off-balance-sheet factors have an important bearing on cash flows that the
conventional ratio takes no cognizance of.
The earnings coverage ratio affords better prospect of measuring risk in the individual company
in terms of the factors that bear directly on cash adequacy. The greater the prospective
fluctuation in earnings, the higher is the required ratio. The limitations of this standard as a
basis for internal determination of debt capacity are:
The net earnings figure from the income statement and derived under normal
accounting procedures is not the same thing as the net cash inflow. In times of rapid
change we are concerned about the hazards of debt burden, and then there are likely
to be sharp differences between net income and net cash flow.
The question what the proper ratio is between earnings and debt servicing is
problematical.
The primary concern with debt is with what might happen during a general or industry
recession when sales and profits are depressed by factors beyond the immediate control of
management. An internal risk analysis must concern itself directly with the factors that make for
changes in cash inflow and outflow. The problem is thus a company-wide problem. The
proposed analysis includes:
(1) Identification of primary factors that produce major changes in cash flows with
particular reference to contractions in cash flow. The most significant factor will be
sales volume, many other factors will also be related to sales, but also level of raw-
materials inventory or responses of management at all levels to the observed
changes in sale for example.
(2) Extent of refinement desired: in their simplest form, cash flows can be considered
in terms of accounting approximations derived from BS and IS data.
(3) Analysis of behaviour: observe individual behaviour of factors affecting the cash
flow. Past experience will suggest a range of recession behaviour that describes
the outside limits of what recession can be expected to do in the future (maximum
favourable and maximum adverse limit).
(4) Expected range of recession behaviour: focus on the adverse limit, since we’re
attempting to assess the chances of running out of cash.
In order to measure precisely the risk of cash insolvency, we need estimates of probability that
are within the expected range of behaviour and not just limits of behaviour. It is difficult to
accurately describe patterns of adjustment over time and to assess the varying degrees of
interdependence among the variables. Furthermore, past recession periods may not have
