FNCE 4101 Week 8 Capital Structure Analysis Example

How Much Debt Should Halvorsen Industrial Supply Carry? Market-Value Weights Today, the Cost of Capital, Coverage and Implied Rating at 20 to 50 Percent Debt, and Why the Lowest WACC Is Not the Answer

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Walden University

FNCE 4101: Corporate Finance

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Month Day, Year

How Much Debt Should Halvorsen Industrial Supply Carry? Market-Value Weights Today, the Cost of Capital, Coverage and Implied Rating at 20 to 50 Percent Debt, and Why the Lowest WACC Is Not the Answer

The Current Mix at Market Value

Halvorsen Industrial Supply, our composite case company, has 60 million shares trading at $30.00 and $600 million face value of 5 percent bonds due in 2033 trading at 95.0 percent of face.

At market value, debt is about 24 percent of capital. Interest coverage, operating income of $185 million divided by $30 million of interest, is 6.2 times. On the coverage-to-rating scale used below, that sits between the A and AA bands, a comfortable position for a cyclical business. The question is whether Halvorsen is leaving value on the table by borrowing so little, or whether its current cushion is worth what it costs.

Table 1

Halvorsen's Capital Structure at Market Value (in millions of dollars)

Composite company. Book equity of about $940 million would put debt near 39 percent of book capital, overstating its weight.

Four Debt Levels Compared

The table below holds total capital at $2,370 million and operating income at $185 million, and asks what happens at four debt levels. The cost of equity rises with debt because shareholders bear more risk; beta is relevered from an unlevered beta of 0.89 using the Hamada relation. The cost of debt rises as coverage falls and lenders demand more.

Table 2

Cost of Capital, Coverage and Implied Rating at Four Debt Levels

Ratings implied from coverage using a published coverage-to-rating table of the kind Damodaran maintains; costs of debt are illustrative spreads over a 4.3 percent Treasury yield.

The Tension

The weighted average cost of capital barely moves between 20 and 40 percent debt, from 8.44 to 8.41 percent, with a low of 8.36 percent at 30 percent. Over the same range, interest coverage falls from 7.7 times to 3.3 times and the implied rating drops from AA to A minus. A table built only on the cost of capital would suggest moving to 30 percent debt to save about 0.14 percentage points. The coverage row says the company would give up much of its cushion to get that saving.

What the Table Cannot Show

Three costs of higher debt do not appear in the weighted average cost of capital.

Flexibility. Halvorsen plans to open warehouses and may want to buy smaller distributors. Graham and Harvey (2001) found that financial flexibility was the factor chief financial officers cited most often in setting debt policy. At 40 percent debt, the company would have little room to borrow for an acquisition without falling to a speculative-grade rating.

Covenants. Bank loans and new bonds issued at lower ratings typically carry covenants limiting further borrowing, dividends and asset sales. At the 50 percent column, lenders would likely cap total debt relative to earnings, a limit that would restrict management's choices in a downturn.

Cyclicality. Halvorsen sells to factories, and its operating income fell by more than a third in the last industrial recession. If operating income fell by a third at 40 percent debt, coverage would fall to about 2.2 times, the range where the rating drops toward speculative grade and borrowing costs jump. Myers (1984) described firms as preferring to keep spare debt capacity for exactly this reason.

Recommendation

Halvorsen should move gradually toward about 30 percent debt at market value, not beyond, and only as it finds investments to fund. At that level the weighted average cost of capital is at its lowest, coverage stays near 5 times and the implied rating remains in the A category, preserving access to the bond market in a downturn. It should not borrow simply to buy back shares to reach 30 percent; the saving is too small to justify losing flexibility without a use for the money. If the company's operating income became more stable, for example through long-term service contracts, a higher debt level would become defensible (Brealey et al., 2020).

References

Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of corporate finance (13th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 575-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x