Debt and Leverage Model Answers

Definitions:

OCS: refers to ideal mix of debt and equity which forms a company’s gearing ratio = LTD/LTD+E.

CF = NOPAT + D + A

FCF= NOPAT + D + A - Period investment

Business economic cycle refers to wider economy.

Company economic lifecycle refers to whether company is nascent, established, or mature.

OCS: Management of the company's debt structure is arguably the FD's paramount
responsibility. Maximising value through sufficient gearing, ensuring adequate
funds for growth at lowest continuing cost, achieving top-rated performance based
on analysts' and the financial markets' key evaluative criteria: ROE (ROI) and CFROI.

H5 Identify and briefly explain the TWO (2) primary Lessons Learned from the Two
Sides of Leverage workshop.

NOTE: Identify only the two most important Lessons Learned. If you list more than the specified
number, only the first TWO (2) that you present will be considered. 


1. Leverage exaggerates the consequences of both good and bad business decisions.
Borrowing allows companies to take a larger stake with extra cash raised from loans an debt,
resulting in higher payoffs if the investment is successful, but conversely greater losses if the
project is unsuccessful. 


2. Increasing gearing can increase company worth through lowering WACC, because the after
tax cost of debt is 2-2.5x lower than after tax cost of equity. CHECK THIS. Lower WACC rate
means higher DCF value of forward Cash flows (NOPAT + DA).


H7 Consider the statement that follows. Do you agree? Do you disagree? Both?
Neither? The statement:

"Adding debt to the company's capital mix ALWAYS results in a higher company and share
price, reflecting the resultant lower WACC rate."

Increasing gearing can reduce WACC because after tax cost of debt is 2-2.5x lower than after tax
cost of equity. Thus in the WACC formula, this lowers WACC, which in a DCF calculation lowers
the discounting rate, meaning future cash flows are more valuable. However this is not always the
case. 


If a company is already highly geared, then their probability of default is heightened because of
high interest expense. In this case given the limited liability of equity, the cost of equity
dramatically increases because ERP is higher. This also increases cost of new debt because of
higher default probabilities, resulting in inability to rollover debt, possible covenant violations, and
use of emergency credit facilities which carry high interest rates. Increased interest expense
results in lower profits, company’s may divert CF away from CAPEX to meet debt servicing
requirements, and cash reserves deplete which increases exposure to unforeseen shocks.

H8 Describe defaulting on senior debt as similar to and yet different from

bankruptcy.

Defaulting on senior debt arises when a company can’t meet interest repayments, and/or repay
the principal on the debt, ie the amount due at maturity. AKA can’t meet sinking fund or balloon
payments. This drives the company insolvent given that it doesn’t have enough cash to meet
current liabilities. If the company doesn’t secure emergency financing through a rights offering,
capital insurance, selling of assets, issuing or restructuring of new debt, in order to meet current
short term liabilities, then bankruptcy will be declared. But bankruptcy isn’t the same as
insolvency. It is an administrative declaration which could be a result of other reasons, however,
corporate insolvency from defaulting on debt is a frequent reason for bankruptcy.

 Debt and Leverage Model Answers

H9 This question is comprised of FOUR (4) parts. You are to answer ALL FOUR
parts, A-D. ALSO H27.

A What's the difference between principal and interest?

B Which of the two elements in A, above, is involved in CADS?

C What is the significance and use of CADS? What are that metric's strengths and weaknesses?

D Which methods, measures or methodologies should supplement CADS for the purpose that
metric is intended? Why is each of those supplements necessary for that purpose?

A. Principal is the initial amount of money borrowed, which the borrower must either repay at
maturity under balloon payment arrangements, or throughout the lifecycle of the debt under
sinking fund arrangements where interest and principal are repaid at the same time - this is
usually implemented for companies with risky credit ratings which are more likely to default on
debt.

Interest is the rate set on the principal which the borrower has to repay at set periods during he
life of the bond. This depends on the company’s credit risk and the lender’s own cost of funds.


B. CADS stands for cash available for debt servicing. = Cash and equivalents on balance sheet/
(Principal + Interest). Both principal and interest are used in calculating CADS. 


C. CADS is a measure of debt servicing ability of a corporate, i.e ability to meet principal and
interest payments. Its strengths include that uses cash in the numerator, which as per Stern 1974
and Copeland et al is most relevant to a company’s worth. The metric is also easy to calculate,
with cash, principal and interest figures easily available in company earnings reports.



However, there are weaknesses. Cash on balance is the measure of cash used and is only one of
the possible sources for debt servicing: company could also raise cash from asset divestments,
expense cutbacks, and other financing. These aren’t necessarily reflected in cash on balance
sheet. Where CFOs run negative cash balances, CADS doesn’t provide an accurate indication of
debt servicing ability. 


D. TIE = times interest earned = net income/ interest expense. Using TIE and CADS together
gives a more complete picture of company’s debt servicing situation.



However, TIE has issues. Net income in the numerator is not the best measure of funds available
to service debt as excess Cash Flows are (NOPAT + D + A). Also, funds freed from more efficient
working capital management, asset divestments and new financings are additional sources of
cash which could be used to pay down debt. Another flaw is that only interest expense is in the
ratio, not interest and principal.



Other measures to be used with CADS and TIE include: maturity profile and Altman’s Z Score.

On maturity profile, lumpy maturity profile can create solvency issues for companies if they have
large principals to pay off all in one go. In this case, the possibility to rollover debt becomes less
likely given the amounts that would be needed to meet multiple maturities in one go. Smoother
maturity profiles allow more predictable financing and less surprises for bankers, and thus less
surprises to cost of financing.



Altman’s Z score also provides insights from a lender’s prospective. It is a measure of credit risk
used by banks to determine whether to rollover debt and loans. A deteriorating Z score indicates
higher credit risk and lower likelihood of refinancing. This can cause issues for solvent companies,
because if one banking pulls funding, Z score decreases, which leads to even more bankers
pulling funding = liquidity crisis and insolvency because bank can’t rollover debt. Reducing
lumpiness of maturity profile and/or raising new equity through a rights offering are ways of
preventing insolvency and deteriorating Z scores.

Z score may also shorten CAP = CFROI/WACC. Lower z score increases cost of debt, which
increases WACC which reduces CAP. If CFROI < WACC then value destructive.

 Debt and Leverage Model Answers

H28 Discuss similarities and differences between Z-Score and credit rating
evaluations from Moody’s.

Both deal with corporate credit worthiness through assessing companies and financing
instruments. 


Altman’s Z score is a proprietary algorithm used by banks to assist in assessing whether

corporates may encounter debt servicing problems in the foreseeable future. It incorporates
CADS, DCF and TIE.


Moody’s is one of three credit ratings agencies, inc S+P and Fitch. They are third party credit
ratings agencies which evaluate capital structure and financing instruments issued by companies.
They assign letter ratings to each type of debt. Changes in these ratings often have immediate
impacts on the cost of debt, because of the close relationship between risk and cost. Borrowers
also find it harder to raise debt when they have lower credit ratings, because cost of debt is
higher, and there is less of a market for more risky securities as pension funds and institutional
investors have limits on the types of debt they can invest in, usually IG, not HY. 


H18 Describe the calculation issue or issues relating to an aspect of “Static

Tradeoff” OTHER THAN ‘tax shield from debt interest’ (aka tax cover).

Two considerations are:

1. Tax shield of debt (1-t)(intexp), but also rising interest expense (other side of tax shield)

2. Probability of default on senior debt caused by inability to service interest and principal
repayments.

1. Interest repayments on debt are tax deductible, which contribute to after tax cost of debt being
2-2.5x lower than equity. However, there is some difficulty in separating tax cover attributable
solely to debt from tax over from other sources of financing.

2. Calculating probability of default as it involves guessing a range of variables including: interior

cash generation, broader economic conditions, credit tightness, changes in maturity schedules
and refinancing ability. Anticipatory methods such as Altman’s Z score can also result in higher
default probabilities if one bank pulls funding based on deteriorating Z scores, resulting in other
banks also pulling funding resulting in a company not being able to rollover debt and meet
maturity/interest payments.

H19 Demonstrating your deep understanding of WACC, explain the likely effects on
the companies comprising the FTSE 100 resulting from a significant reduction in the
10 year gilts rate by the Bank of England.

Give WACC formula definition. 10 year gilts are RfR sovereign debt, which directly influences COE
and COD. Even if there were no changes in levels of equity or debt, a reduction in RfR would
reduce WACC through both reducing the CoE and CoD. This would boost the FTSE100 as a
whole because the discounting rate WACC would be lower, so the PV of future cash flows
generated by companies in the FTSE would increase = increased company wealth (Copeland et al
94).

Given that a decrease in RfR reduces the CoD more than it does the CoE, we could expect
corporate bond issuance to increase to take advantage of lower financing rates. Thus WACC
would lower further assuming a company is not over levered, resulting in even high PV of forward
Cash Flows and thus higher share prices.

 Debt and Leverage Model Answers

H20 Consider the following statement. Do you agree? Do you disagree? Both?
Neither? Provide your reasoning to support your contention.

The statement:

“WACC is a theoretical construct only and has no bearing at all to anything of concern to the
corporation’s FD.”


Statement is wrong. 


WACC definition. 


WACC is very important to CFOs. CFO decisions on levels of debt and equity to hold directly
affect WACC, and thus company value, as company value as per Copeland et al 1994 and Stern
1974 (EPS doesn’t count) is the PV of forward cash flows, discounted at WACC. Thus minimising
WACC, increases company worth. 


WACC also sets the hurdle rate on CAPEX as it is the cost of finance. A project is worth
undertaking to boost corporate value if CFROI > WACC = CAP. The value of a project is
calculated through DCF single hurdle or multiple hurdle methodology, where WACC is used as the
best practice discounting rate. 


H23 In debt servicing, explain the TWO considerations pertaining to maturities.

The size and timing of maturities are two considerations pertaining to maturities. It is in the CFOs
best interests to reduce lumpiness of maturity profiles to signal efficiency of financial planning and
so that the firm doesn’t default on debt when principal repayments are due under balloon
payment type debt. If a firm has large maturity repayments all at the same time, this can cause
insolvency because the firm can’t obtain new debt to rollover existing debt and meet principal
repayments. If the firm doesn’t issue new equity to raise funds, then it will go insolvent. Altman Z
score may also be impacted by lumpy maturity profiles which heighten default probabilities.

H24 Describe sequence of TWO (2) separate actions in which ALL THREE (3) of the
distinct approaches for dealing with dangerously excessive gearing are manifested.

1. Debt first swapped for equity (simultaneously boosts equity and reduces debt). 2. New equity
is raised to pay down long term debt.

H26 Consider the statement that follows. Do you agree? Do you disagree? Both?
Neither? Provide your reasoning to support your position.

The statement:

"When it came to OCS, George Eastman was spot-on, that is, exactly right.”


Eastman was wrong. He operated Eastman Kodak with 5% gearing, due to concerns over
defaulting on debt which didn’t maximise MSV. Not levering up can be damaging to company
value as WACC isn’t minimised with 95% equity and 5% debt. Issuing new debt would lower
WACC, which would result in higher PV of future CF, boosting company worth. This is because
after tax cost of debt is 2-2.5x lower than after tax cost of equity (due to primacy of debt over
equity, tax deductibility and no ownership rights). Cash raised from new debt could also be used
to fund international expansion opportunities and new CAPEX. Such low gearing also makes
companies a takeover target from PE firms looking to perform leveraged buyouts, where they
issue debt to raise cash to buy out a company. A 5% gearing ratio makes Eastman Kodak a
particularly easy target. 

 Debt and Leverage Model Answers
H31 Consider the following statement. Do you agree? Do you disagree? Both?
Neither? Provide your reasoning to support your statement. ALSO IN GENERAL
100s.

The statement:

"In a way, 'balloon' and 'sinking fund' are opposites.”

In a balloon payment arrangement, repayment of principal occurs at maturity when the

bond matures. This is typically the case for most credit worthy companies.

In a sinking fund arrangement, creditors are less confident of a company’s ability to repay
both interest and principal, thus require the borrower to pay interest and part of the
principal periodically so that they aren’t left as out of pocket at maturity if the company
defaults on LTD and can’t repay the principal.

H32 Discuss how- in the most recent cycle- QE distorts OCS strategy based on
capital component business-economic relative life cycle costs.

Typically later in a business- economic cycle, the cost of debt increases due to rising interest
rates. This also affects the cost of equity, but CoE decreases because less shares have to be
issued to raise a required amount of financing given equity markets are likely to be near all time
highs. Thus we would expect CFOs to raise equity for new financing late stage, instead of issuing
new debt. However, QE, which stands for quantitative easing, where CBs around the world have
been buying debt for prolonged periods of time, has resulted in yields remaining low. This coupled
with continued easy monetary policy and lower returns to debt pushing investors more into equity
has resulted in cost of debt and cost of equity remaining low. Thus given that the after tax cost of
equity is 2-2.5x higher than the after tax cost of debt, because of the tax shield of debt, where
interest repayments are tax deductible, CFOs have continued to add debt to their capital
structures.

 Debt and Leverage Model Answers

H33 A recurring error in some past unseen final examinations for this course
involves confusing two similar-sounding OCS alternatives which in reality differ
significantly. Business-economic cycle financing element costs, as contrasted with
an individual firm's financing costs over that company's economic life.

A student in the class less proficient than you has asked you for some assistance in
understanding the difference between the two.

Provide your response to that student. 


Business economic cycle refers to stage of the economic cycle in the macroeconomy as in H32.

Company economic lifecycle refers to the development of the company. There are three stages in
company maturity: nascent, industry leader, and mature.

Nascent companies often face the highest financing costs as they aren’t big enough to access
debt funding and instead have to rely on angel investor equity, the cost of which is extremely high
given the company’s infancy and fact that its business model isn’t proven and it may not generate
positive CF yet.

Sector leaders often have the cheapest WACC and financing terms given that they are industry
leaders, with publicly traded equity and access to LTD, credit facilities. These companies generate
enough cash flows to support higher gearing and associated interest expense and principal
repayments. There is still the issue of maturity profiles, and effective debt management (TIE and
CADS) but if the company can adequately service debt then it should achieve low WACC.

Mature players are players that are losing ground to new entrants, such as IBM, HP.
Misadventures in CAPEX can lead to balance sheet impairments, CF that no longer grows due to
market share erosion. This erodes creditor confidence in the company and raises doubts over
debt servicing capabilities, thus reducing the amount financing the company can obtain. 



Higher cost of debt and equity results from higher risk of default on senior debt and operational
risk of becoming non-competitive and declining. This pushes up WACC, reducing company value
on a DCF measurement basis, increasing the hurdle rate for CAPEX, which may result in less new
CAPEX taking place because there aren’t enough ideas in the pipeline which generate CFROI >
WACC, and thus are worthwhile instead of being value destructive. This accelerates a company’s
inability to keep up with competitors through innovation.

H34 List advantages and disadvantages of the OCS approach deployed by General
Motors, as studied in this course.

GM secured a stand by non cancellable credit line of $3Bn for later use. 


Advantages: When the company got into distress during the financial crisis, they could all upon
this guaranteed credit facility despite other facilities not being available. An annual stand by fee is
paid instead of interest payments on debt. 


Disadvantages: Not useful for day to day financing requirements as it is emergency in nature.
Annual fees are required to maintain access to the facility. When the facility is drawn upon, it is a
signal to the financial community that the company is in distress, with no other funds available to
it.

 Debt and Leverage Model Answers

H35 Explain the following statement: "As commonly applied, Pecking Order
contains a fatal error, whereas that approach's polar opposite provides the CFO-FD
with an unassailable negotiating edge critical to successful financing planning."

Pecking order and static trade off are the two most extensively cited OCS approaches. OCS
strategies strive to achieve an ideal mix of debt and equity to support day to day operations,
CAPEX and future growth.

Pecking Order’s calls for using the lowest cost financing when a funding requirement arises. Its
fatal flaw is that it assumes that cash on balance sheet is free. Cash is not free. It at least has a
cost of WACC, but if cash on balance sheet is from equity offerings or rights offerings, then the
cost of cash will be significantly higher given that equity is one of the most expensive forms of
financing.

The polar opposite is leading with debt, which is 2-2.5x cheaper after tax than equity financing
given the tax deductibility of debt.

H39 Explain the following statement: "Pecking Order's prescribed tactic must later
be radically reversed if and when applied to extreme."

NOTE: This question does NOT concern any presumptions relating to the cost of cash.

Under pecking order, one of the leading OCS strategies, CFOs should meet new financing
requirements with the cheapest cost of funding. Pecking order assumes that cash is free
and thus cash should be used. But this assumption is wrong as cash costs at minimum
WACC, and even the cost of equity if it is in the form of retained earnings. Thus the
actual cheapest form of financing is debt, which after tax is 2-2.5x cheaper than the equity
given the tax deductibility of debt.

However, leading with debt indefinitely, raises company gearing (LTD/LTD+E) to

unsustainable levels and could result in a company going insolvent through not being able
to meet its short term liabilities and interest expense. Cost of equity also soars in CAPM
when gearing is excessive because of heightened risk of default, and because of the
limited liability of equity where returns aren’t guaranteed. Increased interest expense
results in lower profits, company’s may divert CF away from CAPEX to meet debt servicing
requirements, and cash reserves deplete which increases exposure to unforeseen shocks.
Company value in this case would plunge as WACC rises, and company value as per
Stern 1974 and Copeland et al 1994 is the PV of future CF discounted at WACC.
Increasing WACC reduces this PV.

Also if a company is over levered, it may not be able to secure rollover financing to meet
principal repayments, a problem made even worse if maturity profile is lumpy and there
are many maturities bunched together.

In such an event, new financing through a rights offering or debt restructuring would have
to be negotiated for the firm to not declare bankruptcy.
 Debt and Leverage Model Answers
H52 Starting with the one component of CAPM also representing the start point in
CoD diagnosis, describe how a term loan debt costs arise, identifying all salient
components.

RfR (US 10 year treasures or UK 10 year gilts), the interest rate on these government securities
which are assumed to be free from default risk. This forms the basis for both cost of equity as per
CAPM and cost of debt.

Banks then apply a markup to these RfR which is their interest margin. This markup depends on
the bank’s risk tolerance, cost of funding, equity buffers, deposit funding and the borrower’s credit
worthiness and thus ability to repay both interest and principal, and probability of default.
Altman’s Z score and ratings from credit ratings agencies could be used here to establish the
borrower’s financial health.



The bank will implement covenants on loans to prevent firms from for example raising excessive
debt finance with other banks which would reduce its ability to repay on existing debt.

H61

This question is comprised of THREE (3) parts.

Describe the separate (A) financial operational and (B) component financing cost-basis,
and (C) replacement cost reasoning for why the Pecking Order ‘cash is free’ contention is
indefensible.

Pecking order, along with static tradeoff, are the two most widely used OCS measures which
pertain to CFOs optimising gearing to maximise shareholder value and ensure adequate funds are
available at minimum WACC to ensure day to day financing requirements and company growth
objectives and CAPEX.

Pecking order prescribes meeting new financing requirements with the cheapest form of
financing, however, it wrongly assumes that cash is the cheapest source before debt, because of
the assumption that cash is free. This is not the case.

Financial Operation:
Proficient CFOs look to minimise cash whilst retaining sufficient liquidity on balance sheet as cash
doesn’t earn anything. It would be better used invested in risk free assets, or in new or
maintenance CAPEX projects. Short term cash needs could in large companies be met with credit
facilities, thus eliminating the need for cash on balance sheet, undermining cash as a significant
source of funds for new financing under Pecking Order.

Component financing cost:

Retained earnings, which are a form of cash, constitute shareholder equity. Thus it carries the
cost of equity as per CAPM, and possibly more if cash raised was from rights offerings. There are
also other sources of cash on balance sheet such as cash raised from asset divestitures, better
working capital management, converting trade payables into debt, and long term debt. These all
carry positive, definable costs.

Replacement:
The replacement cost of cash is the cost of raising new cash. Under NPV/ DCF CAPEX
approaches which require new incremental financing, the cost of cash to fund a new project is
available at WACC. However, this is not guaranteed forever given that cash available isn’t
unlimited. But it at least indicates that the cost of cash is positive.

 Debt and Leverage Model Answers

H93 Explain the following excerpt from your assigned reading in Joel Stern’s 1976
Financial Analysts Journal paper-article:

“The real benefit of debt financing to the common shareholders is... government tax
savings.”

Debt servicing requires repayment of both interest and principal. Stern is referring to the interest
tax deductibility of debt, which makes the cost of debt 2-2.5x cheaper than the cost of equity,
along with the fact that debt is first in line for repayment under liquidation and thus is less risky
than equity.

To common shareholders, companies that lead with debt for new financing and have optimised
gearing ratios of LTD/LTD + E tend to have lower WACC (give definition of WACC). Lower WACC
results in higher company value and share prices, because company value as per Stern 1974 and
Copeland et al 1994, the value of a company is the PV of its forward cash flows discounted at
WACC (DCF methodology).

H94 From the perspective of the company’s value-maximising FD, what are the
POSITIVES (PRO) and NEGATIVES (CON) associated with the THREE (3) distinct,
alternative options for dealing with dangerously excessive gearing, as identified
both in Business Briefings p. 12 and also in Week 6 Lecture Slides?

Gearing = LTD/ LTD + E. Excessive gearing is dangerous as it increases a company’s default

probability on senior debt. Default occurs when a company can’t meet periodic interest expense,
and/or fails to repay principal on debt at maturity. Excessive gearing increases profits if additional
cash raised from debt funding is used in productive investment, i.e it allows the company to take
bigger bets. The flip side is that losses are also bigger.

Gearing can be reduced in 3 ways:

1. Selling off or paying down debt. 

Pros: This directly impacts the maturity profile of a company and reduces outstanding
principal amounts and interest expense in one move. This can be achieved through issuing
callable bonds when raising finance, which give the company the option to buy back debt
before maturity. 

Cons: LTD may span numerous forms of debt instruments, which the borrower may not be
able to buy back before maturity (bullet bonds), or which may be exotic and thus have limited
transferability and liquidity.

2. Debt for equity swap: 


Pro: Simultaneously reduces LTD and increases equity, thus bringing down gearing through
two channels. 

Cons: Transfer costs, doesn’t reduce overall P+ I burdens, no additional financing to support
company’s future operations or growth.

3. Issue new equity:


Pros: Immediately reduces gearing through increasing E, adds to the company’s base of
permanent capital allowing it to meet unexpected liquidity issues and expenses, also signals
to financial markets that it could be a candidate for more debt financing despite history of
excessive leverage. 

Cons: Rights offerings 20-30% more expensive than IPOs because they are emergency
sources of funding. WACC increases which reduces company value, thus hurdle rate for new
CAPEX increases which results in some previously worthwhile projects not taking place,
DILUTION.

 Debt and Leverage Model Answers

8 (22) What did M&M miss?
Capital structure (D/E) doesn’t matter because risk is offset by required return. They assumed that
debt and equity cost the same.

- Return on equity ROE increases proportionately with gearing and inversely with cost of debt,
but risk increases proportionately with gearing so increased borrowing has no effect on
business value.

- M+M ignored deductibility of interest on debt, the threat of insolvency at high gearing ratios,
the threat of acquisition at low gearing ratios and transfer costs of switching between debt and
equity forms of financing.

- Instead after tax cost of debt is 2-2.5x cheaper than equity because of tax deductibility of
interest and because of primacy of debt and the fact that debt holders don’t have ownership
rights over a company whereas equity holders do.

- Companies seek maximum leverage to boost ROE, however, this after a certain amount of
gearing can increase cost of financing because beta increases significantly when companies
are highly levered, and interest and principal burdens lower debt servicing ability, leading to
higher default probability which increases the cost of finance.