Session 22: Moving to the Optimal Financing Mix

In session 22 of this 36 session corporate finance class, I'd like to talk about what to do once you've come up with the optimal. In particular, I'd like to deal with two questions. The first is how urgently you need to move from where you are right now, your actual debt ratio, to the optimal, and how you might actually make that move. In these last five sessions, we've talked about the trade-off that animates the choice between debt and equity. And we've looked at three different approaches you can use to come up with that optimal debt ratio. The cost of capital approach, we try to minimize the cost of capital, or more generally, maximize the value of your business. The APV approach, we have the same objective. And the sector approach, we look at other companies in the sector and try to finesse the choice by trying to get as close to the sector average as you can. Let's say you now got the optimal. In this session, I'd like to complete this discussion by talking about what next. In other words, if your optimal is different from the actual debt ratio, how quickly do you need to fix a problem, and how should you fix a problem? So basically, there are a couple of questions I'm going to try to address. The first question is the one of urgency. If you have too little debt, is it a problem? And if it's a problem, how quickly do you need to fix it? If you have too much debt, is it an immediate problem, an urgent problem? And if so, how should you fix it? So the first issue I want to talk about is the urgency with which you need to fix a problem. The second is, you have to look at different ways of fixing the problem. And there are two basic ways, or two general ways of fixing a debt problem, or a debt mix problem. The first is to recapitalize. There you keep your business fixed and change your mix of debt and equity. So if you want to increase your debt ratio, you borrow money and perhaps buy back stock or pay a dividend. If you want to decrease your debt ratio, you issue equity and retire debt, or do something similar. So essentially, you have to make a judgment on recapitalization, or here's the other choice. You can go out and take new investments, right? You're saying, how is it I'm going to fix my debt ratio? If you have too low a debt ratio, you can disproportionately fund those new investments with debt. In other words, use a lot more debt than you normally would on those new investments, and your debt ratio will go up. So the two questions you face when you have the optimal debt ratio is, how quickly do I need to fix this problem, and how should I fix this problem? So I'm going to set up a framework that might or might not help you answer both questions. So in this framework, I start off with a very fundamental question. Let's assume you have the optimal debt ratio for your company, the optimal financing mix, and you compare to the actual financing mix. One of three things is going to be true, right? The first is that your optimal is equal to the actual, in which case you don't have a problem, just let it go. But let's look at the other two choices. The first is that you have too little debt, you're under levered. The other is you have too much debt. At the outset, let me suggest to you that if you're going to have a problem, it's much better to have too little debt than too much debt, and you're going to see in a minute why. Let's say you have too little debt. The first question you need to ask yourself is, how much time do I have? You're saying, what do you mean? If you have too little debt, you're potentially the target of a hostile acquisition, and here's why. Since you have too little debt, an acquirer can, in a sense, use your assets as backing to borrow money and use that debt to buy you out. It is, in fact, the ultimate insult, but it can happen to you. So if you have too little debt, that's my first question. Are you potentially the target of a hostile acquisition? Now you might wonder, how am I going to answer that question? I would suggest you look at three things. The first is, look at the size of your company. The larger a company gets, the more difficult it becomes to do a hostile acquisition of your company. So if I told you in 2014 that Apple was under levered, there's too little debt, there's not a whole lot you can do about it, because it's a $600 billion company. And buying out a $600 billion company is going to be really difficult to do. So first thing you should look at is the size of your company. Bigger companies, all other things being held equal, are going to be more difficult to take over than smaller companies. The second is the control structure of the company. And a couple of things you might want to look at in this context. First is, look at what percentage of the stock is held by insiders. So 35% of the stock is held by insiders who happen to run the company. It's going to be much more difficult for you to do a hostile acquisition of this company, because you've got to buy 51% of the remaining 65%. The other aspect of the control structure to look at is whether the company has voting and non-voting shares. Remember, Vale is voting and non-voting shares. If Vale were under levered, and it's not, you'd still have a tough time doing a hostile acquisition of the company, because the voting shares are held by the insiders. So look at the control structure. And there's a third and final aspect you might want to examine. Every hostile acquisition is, in effect, a fight between two sides. On one side stands a hostile acquirer, telling the stockholders, don't trust the managers, they don't care about you. On the other side stand the manager saying, don't trust the hostile acquirer, he's going to ruin the company. And you as the stockholders get to decide which side to trust. One of the few times stockholders get that power, right? Let me tilt the scales. Let's assume that over the last five years, your stock has dropped 80%. It's been a terrible investment. Which side are you going to trust? I know which side I will. If my stock is down 80%, why would I trust the managers of this company? I'm much more likely to trust the hostile acquirers in that context. So the third thing you might want to look at is how good or bad your stock has been as an investment in the past, after adjusting for risk and after adjusting for market performance. If that sounds mildly familiar, it's because we came up with a measure of that number, right? Earlier when we talked about regression betas, remember we came up with a Jensen's Alpha that measured how good or bad your stock was as an investment. If your stock has a very negative Jensen's Alpha, it's very likely that if somebody mounts a hostile acquisition for your company, that the hostile acquirer is going to win. So look at the size of your company. Look at the control structure. Look at the Jensen's Alpha. And here's your trifecta. If you're a small or mid-sized company with a relatively small insider holding and no differences in voting rights, and you have a negative Jensen's Alpha, you're a much more likely target for a hostile acquisition. If you are the target of a hostile acquisition or a potential target, then do something quickly. You've got to raise the debt ratio fast. And here are a couple of ways you can do it. Go out and borrow money and buy back stock. You could essentially overnight increase your debt ratio from 0% to 30% or from 10% to 50% by doing this. If you're a small enough company, you might even try what's called a debt-for-equity swap. You're saying, what's that? You could approach your equity investors and offer them debt in the company or bonds in the company with equivalent market value. If you can pull that off, again, your debt ratio can increase fairly dramatically overnight. So you don't have time as your ally. Do something quickly. If time is your ally, either because you're a big company or you have a controlled structure that's going to prevent hostile acquisitions or because your Jensen's Alpha looks good, then use that time to map out a long-term plan to bring your debt ratio up. And to make that long-term plan work, you've got to answer a follow-up question. Do you have good investments? And to answer that question, be honest. Look at your past investments. If you remember, a few sessions ago, we talked about looking at the return on invested capital as a proxy for the quality of your investments. And we said that a company that takes on good investments should be able to earn a return on invested capital that exceeds the cost of capital. See if that's true in your company. If your company has been generating excess returns, has been earning good returns on capital, then you have some leeway in increasing your debt ratio. In particular, that suggests to me that you have good projects. And if you have good projects and excess debt capacity, I think you have a marriage made in heaven. Go out and borrow money and take those good projects. And over time, your debt ratio should go up. If you don't have good investments, don't fight the project pipeline. In that case, try to increase your debt ratio by either increasing dividends over time or doing stock buybacks over time. Which one you do will depend on what kind of stock orders you have and which one they'd prefer to get. So again, if you're under 11, ask yourself, am I potentially the target of a hostile acquisition? If the answer is yes, do something quickly. If the answer is no, look at the quality of your projects. If you have good projects, take those projects with debt. You get a double whammy. In addition to increasing your value because you go to the optimal mix, you now get the positive net present values of the projects you take. If you don't have good projects, either increase dividends or go out and borrow money and buy back stock gradually. And over time, your debt ratio should go up. Now let's look at the other problem. And this is the most serious and more daunting problem. What if you have too much debt? If you have too much debt, again, the question I would ask is how much time do you have? And here there's a morbid ring to the question because what I'm worried about is not being taken over but going bankrupt, right? Is your company under threat of bankruptcy? Now to answer that question, you might look at your actual rating, you might look at your interest coverage ratio, but the reality is if you're having trouble making debt payments, you will know, right? Because you're scraping the bottom of the barrel to come up with the cash flows every quarter to make your interest payments. If you're in trouble, if you're under threat of bankruptcy, then you have to bring your debt ratio down quickly. And I could suggest some paths, but every one of them is going to be tough because everybody knows you're in trouble. And so let's try some. You could try to sell your assets or some of your assets and use the cash to pay down debt, right? Sounds easy until you go out to try to sell your assets. Everybody knows you're desperate. You know what's going to happen to your bargaining power? It's going to be shot to hell. So when you try to sell those assets, you're going to get a fraction of what you think they're worth. You could try to issue equity, but remember again, you're in deep trouble. Everybody knows you're in deep trouble. It's going to be difficult to get them to buy your shares. In fact, the only bargaining chip you have that you might want to consider playing is remember if you're in this much trouble, you can threaten to go bankrupt. You're saying, how does that help me? Well, remember what happens to lenders in bankruptcy. They have to wait at the end of the line and bankruptcy lawyers collect a big chunk of your assets, right? So what you do is you use a threat of going bankrupt to extract better terms from lenders. I know it sounds unethical, but you're pushing the only strength you have left. So you go to your lenders and you ask them to either take equity in the business, or you ask them to offer you better terms in the debt. That's a restructuring talk that you often hear in the context of trouble companies. And if you're lucky, maybe you'll come out of this process with debt that you can actually afford to pay down over time. If you're not under bankruptcy threat, then you have the same question you had when you were under level. Do you have good projects? Because if you have good projects, here's the most painless way to reduce your debt ratio over time. Fund those projects predominantly or primarily with equity, either with retained earnings or new equity issues. Over time, your equity value will go up. And even if you don't pay down a dollar of debt, your debt ratio should go down. If you don't have good projects, then you essentially have to try to still pay down the debt, but you can do it gradually over time using retained earnings. In fact, if you're paying dividends, please stop. Because if you're already over levered, you should not be paying dividends. So in summary, if you're over levered and you're under bankruptcy threat, and you have to do something quickly, try to do the best you can with your biggest bargaining chip, which is you could go bankrupt. If you're not under bankruptcy threat and you've good projects, take those projects primarily with equity and your problem will go away. If you don't have good projects, then figure out ways to pay down the debt with retained earnings over time and your debt ratio should decrease over time. So let's try this framework on Disney. It's an under-levered firm, right? It's at its actual debt ratio of 11.5%. It's well below the optimal of 40% we computed for it. Is it potentially the target of a hostile acquisition? In 2013, I decided it was not, and here's why. It's a relatively large firm with a great Jensen's Alpha. The Jensen's Alpha, if you remember, that we computed for Disney was 9%. It's basically done 9% better than expected over the last five years. The control structure actually doesn't stop a hostile acquisition, but given its large market cap and its positive Jensen's Alpha, I'm gonna conclude that it's not the target of a hostile acquisition. To give you some sense of perspective, that's a judgment I've varied across the time. In 97, I decided Disney was not the potential target of a hostile acquisition. In 2003, I decided it could be the target of a hostile acquisition because its market cap had dropped and investors were mad at the company. In 2013, I'm back to deciding that it's no longer the target of a hostile acquisition. The point I'm trying to make is the same company can make transitions back and forth on this judgment, so make it afresh every time you look at a company. Because it's not the target of a hostile acquisition, I have the luxury of time. So I ask the follow-up question, does it have good investments? And here again, I looked at a number we've already computed for Disney, the return on capital, which if you remember from a prior session, prior session for Disney was 12.61%, 4.8% higher than their cost of capital. That tells me that at least looking at history, that Disney's had good investments. And if I assume that these good investments will continue into the future, what I'd suggest that Disney do, given their excess debt capacity and given that they have good investments, is find more good investments. So build a theme park in Shanghai with more debt. Expand ESPN if you need to into Latin America with more debt. By taking these new investments with more debt, your debt ratio will go up and you will get the positive net present values because these are good investments. That is the framework you should be thinking about applying for any company. And you can try that for any company that you want. So when you do get a chance, try this for a company. Get the optimal debt ratio using any of the approaches we've talked about. Look at the actual, compare the two. If it's under levered, ask yourself the question, is it the potential target of a hostile acquisition? Going through those three criteria that we suggested. If it's over levered, ask yourself, is it potentially under threat of bankruptcy? If the answer is yes, then you got to do something quickly, right? If you have the luxury of time, then ask a follow-up question. Do I have good investments? And if the answer is yes, map out a long-term plan where you take projects with either new debt or new equity, depending on whether you're under levered or over levered. If you don't have good projects, then think about a long-term plan to bring your debt ratio up if you're under levered or down if you're over levered. That's pretty much the end of the discussion we're going to have on the financing mix. We will move on now to the right kind of debt in the next session. Thank you very much for listening.