It Was In My Other Pocket

Have you ever been short on money and gone through your clothes, only to find a $20 bill that you had forgotten about? We are sure that you were relieved. The same thing just happened to cryptocurrency exchange FTX, which filed for bankruptcy back in November. FTX attorneys announced that the company had found $5 billion in cash, liquid cryptocurrency, and other liquid investments! Of course, it appears that there may be other pockets to check as the total value of missing customer assets is $8 billion.

Liquidity and Bankruptcy

As investors have learned, like any other investment, cryptocurrency is subject to volatility. The recent bankruptcy filing of crypto exchange FTX shows, this volatility can be extreme. For example, the Ontario Teachers' Pension plan wrote down $95 million due to the collapse. As you probably know, bankruptcy occurs when liabilities are greater than assets. However, bankruptcy can result from a finer distinction between liabilities and assets, namely liquidity. In the case of FTX, the company had $8.9 billion in liabilities and $9.6 billion in assets. So was the company forced to declare bankruptcy? Liquidity. When you look at the balance sheet, FTX had $900 million in liquid assets, $5.5 billion in less-liquid assets, and $3.2 billion in illiquid assets. Think about it like way: You owe $10,000 at the end of the week but your only asset is a $100,000 house. Yes, your assets are greater than liabilities, but you likely won't be able to sell the house and receive the cash for the sale by the end of the week, so you could be forced into bankruptcy. But FTX had other problems as well. John Ray, who was appointed to oversee the FTX bankruptcy and has overseen other large bankruptcies such as Enron, stated "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

Is There Too Much Corporate Debt?

A common refrain among policy experts is that the corporate debt level is too high. In fact, from 2008 to 2018, corporate debt rose from $2.3 trillion to $5.2 trillion, debt-to-EBITDA has risen, and there has been an increase in the number of companies with junk-rated bonds. So is there really too much corporate debt? A recent article from McKinsey indicates that current debt levels may not be as dire as many would lead you to believe. For example, even though the number of companies with debt rated below BBB- has increased, it appears that the reason is not a general lowering of credit rating, but rather an increase in the overall number of rated companies and companies that previously issued unrated debt now being rated. And while the debt-to-EBITDA ratio has increased, the EBITDA-to-interest ratio for most industries has remained stable over the past 10 years.

In short, it may be that the fear of too much leverage in corporate America is overblown. However, as the article notes, companies should still undertake stress testing to exam the risks associated leverage. If you are not familiar with stress testing, it is similar to scenario analysis in capital budgeting, except we focus on the worst case analysis. Stress testing can indicate scenarios that would place a company in financial distress, allowing for prior preparation if these circumstances should arise.

PG&E Bankruptcy?

In early November, the deadliest wildfire in California history broke out. And while the exact cause has not been determined, the California Department of Forestry and Fire Protection is investigating power lines operated by PG&E as a possible cause. PG&E was previously blamed for a fire that occurred in 2017 and had to issue bonds to pay for claims from that fire even though the state has not issued a report on the cause of that fire. In the textbook, we mentioned that at one point, Continental Airlines filed bankruptcy in order to reduce labor costs. Now, there is a possibility that PG&E may use the bankruptcy process to seek relief from possible financial claims arising from the 2018 fire.

Netflix's Capital Structure

As we discussed in the text, the optimal capital structure for a company is the result of many interacting factors. And while we can observe capital structures in practice, it is less frequent for a company to state its target capital structure. Recently, Netflix announced that was issuing $2 billion in debt to help the company reach its optimal capital structure, which the company said should be 20 to 25 percent debt-to-market capitalization. At the current market value of equity, the company would need to issue between $22 and $30 billion of debt. What makes this debt issue really interesting is that though company is burning through cash, the announced purpose of the bond is to increase leverage.  

Bond Ratings And Mergers

A recent article in Bloomberg highlights a potential threat to the bond market. Recent years have seen a number of high-priced acquisitions funded by debt. As a result, many of these companies have dramatically increased leverage as measured by Debt/EBITDA. This has caused a drop in credit ratings, with $2.47 trillion worth of debt now rated as BBB, more than three times the 2008 level of BBB debt. Even though many of the deals are funded through debt, a common assumption is that synergies and the improved cash flow would allow the company to quickly pay down debt. But a hiccup in the economy or synergies not materializing could limit debt pay down. In the last three recessions, from 7 to 15 percent of investment grades bonds were downgraded to junk status. Given the higher amount of debt with lower credit ratings, a recession in the next couple of years could push a massive amount of corporate debt into junk territory.

The (Partial) Effects Of Tax Reform

With the U.S. corporate tax rate being among the highest among developed economies, there is discussion of corporate tax reform that would reduce the corporate tax rate from 35 percent to 20 percent, as well as the possibility of eliminating the deduction of interest expense entirely. So how would this affect corporate finance? A cut in the corporate tax rate on interest would reduce the attractiveness of debt as a form of financing, thereby reducing the amount of debt in the optimal corporate capital structure. One estimate is that the U.S. average debt-to-EBITDA ratio would drop from 4.1 to about 3 times, which would also affect the other financial leverage ratios. And the non-deductibility of interest expense would affect the calculation of the weighted average cost of capital. And, finally, at least for now, the decline in corporate debt will likely increase the credit rating for the remaining debt, driving the yield down on debt that does remain. All in all, major changes to U.S. based corporations.

Share Repurchases And Value Creation

A recent article on the McKinsey & Company website discusses the effect of dividends versus stock repurchases. We are happy to report that the article comes to the same conclusion as the textbook: Repurchases do not necessarily create value and are equivalent to paying a dividend of the same amount. However, the article does bring out a couple of interesting points. First, while repurchasing debt (re-leveraging the company) results in a higher EPS, this is offset from the lower company risk due to less debt. The value of the company is unchanged (M&M), and the PE ratio should fall. Second, a more important point is that the company should undertake profitable, positive NPV projects, if available, rather than repurchase stock. In other words, a stock repurchase is essentially a capital budgeting project. A company should only repurchase its stock if the NPV from the repurchase is greater than other capital budgeting projects. Of course, if the market is efficient, the NPV from a stock repurchase is zero.

Corporate Leverage Increases

According to Goldman Sachs, the level of debt on corporate balance sheets has risen to a level not seen since before 2008. With record low interest rates, companies have increasingly borrowed to fund buybacks and acquisitions. During 2014, about 10 percent of debt issues were used to fund buybacks. And, so far during 2015, about 8 percent of debt issues have been used for buybacks. Meanwhile, goodwill, which is created from mergers and acquisitions, has risen 32 percent since 2010 and more than $1 trillion in goodwill has been added to corporate balance sheets since 2008. While goodwill can represent real value, such as a brand name, it could also indicate that companies have made negative NPV acquisitions.

Mangerial Idiosyncrasies And Corporate Capital Structure

Coming back for his second appearance, our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

Corporate capital structures generally show a remarkable degree of variation over time.  One under-appreciated source of variation is the unique personal views about appropriate financial policies held by the people running a firm.  There is scope for managers’ idiosyncratic preferences to have a significant influence on the debt-equity mix when taxes and financial distress costs have only a second-order impact on firm value over a reasonably wide range of leverage ratios. 

Coca-Cola’s dramatic shift in capital structure in the 1980s (detailed below) provides a useful illustration of how the idiosyncratic views of top management can radically reshape financial policy.  The Coca-Cola case also highlights how debt can serve as a transitory vehicle for funding investment opportunities.  For more on the latter view, see my previous post.

  

Coca-Cola’s “levering up” of the 1980s: The appointment of Roberto Goizueta as CEO in 1980 marked a sharp shift in Coca-Cola’s financial policies toward more aggressive use of debt, including a willingness to borrow to make acquisitions (e.g., to acquire Columbia Pictures in 1982).  The CEO’s letter to shareholders in the 1985 annual report spelled out the firm’s new financial principles: “In the financial arena, The Coca-Cola Company is pursuing a more aggressive policy.  We are using greater financial leverage whenever strategic investment opportunities are available.  We are reinvesting a larger portion of our earnings by increasing dividends at a lesser rate than earnings per share growth….And, we are continuing to repurchase our common shares when excess cash or debt capacity exceed near-term investment requirements.”  In a 1984 interview, the firm’s CFO stated “We can go up to $1 billion without hurting our triple-A rating, and we would not hesitate to do so if something unusual comes along….” and “we will not hesitate to be a double-A company.  I want to make that very clear.”  The firm did, in fact, lose its triple-A rating because of its more aggressive use of debt. 

The Coca-Cola case study is from “How Stable Are Corporate Capital Structures?” by Harry DeAngelo and Richard Roll, which is forthcoming in the Journal of Finance.  The case appears in the paper’s Internet Appendix, which also contains case studies of 23 other firms that, like Coca-Cola, were (i) in the Dow Jones Industrial Average at some point, and that were (ii) publicly held from before the Great Depression until at least 2000.

Capital Structure Dynamics And Transitory Debt

Our guest blogger this week is Dr. Harry DeAngelo, the Kenneth King Stonier Chair in Business Administration at the Marshall School of Business at USC. Dr. DeAngelo is a noted expert on payout policy, capital structure, and corporate governance. Here, Dr. DeAngelo discusses how transitory debt can affect the capital structure decision. For a more detailed analysis, you can read the entire paper "Capital Structure Dynamics and Capital Structure" here. 

According to the tradeoff theory of capital structure, firms select an optimal leverage ratio by balancing the tax advantages of debt against the potential costs of financial distress.

For simplicity, consider a version of the tradeoff theory in which firms face a corporate tax rate of 35%. Interest payments are tax deductible, but dividend payments are not. Suppose also that any debt-to-assets ratio over 0.45 is almost certain to result in costly financial distress while those less than or equal to 0.45 imply no chance of distress.  The latter knife-edge structure is, of course, unrealistic. But let’s stick with the assumption in order to illustrate an economically important feature of corporate capital structure decisions that is omitted from the traditional tradeoff arguments about optimal capital structure.

What is the optimal capital structure for our hypothetical firm? According to the traditional tradeoff logic, the optimal leverage ratio is 0.45. The firm gets maximum tax benefits by levering up to 0.45, and it runs no risk of incurring financial distress costs. So, by the usual tradeoff logic, the optimal strategy is to fully exhaust debt capacity (take leverage up 0.45) to capture the tax benefits of debt.

That logic is fine in a simple static setting in which a firm is only concerned with balancing tax benefits and distress costs while holding investment policy fixed.

But things change fundamentally when we look at the problem dynamically and recognize that debt policy is about more than finding the right mix of interest and dividend payouts.  Importantly, firms issue debt because it is a low (transaction and asymmetric information) cost vehicle for raising funds for investment.

It is no longer attractive for the firm to lever all the way up to 0.45. Why not? The reason is that the firm would like to have unused borrowing capacity that it can tap in the future if a really attractive investment opportunity arrives. The rational policy is to keep some “dry powder” – untapped debt capacity – available. The one exception would be if the firm currently had an outstanding investment opportunity and probable future investment opportunities that are much less attractive. In that case, it would be rational to exhaust debt capacity today instead of saving “dry powder” for future use.

What should a firm with untapped debt capacity do when an attractive investment opportunity arrives and it doesn’t have sufficient resources to fund it? In most cases, the right response is to borrow to fund that investment and then use future earnings to pay down debt and restore the option to borrow to meet future funding needs.

The firm’s ideal “target” leverage ratio is less than 0.45 once one takes into account the value of the option to borrow to meet future funding needs.

Traditional tradeoff theories view corporate capital structures as having only “permanent” debt and equity components. The dynamic theory that we have sketched here recognizes that capital structures also have a “transitory” debt component that involves the exercise of the option to borrow and then the restoration of that option by subsequently paying down debt.

You can think of this view of capital structure as the corporate analog of the manner in which a rational individual will manage his or her credit card: Use the borrowing capacity to meet unanticipated funding needs and then repay the debt to free up debt capacity for future use.

The logic here is based on “Capital Structure Dynamics and Transitory Debt” by Harry DeAngelo, Linda DeAngelo, and Toni Whited in the Journal of Financial Economics (2011, pp. 235-261).

Mergers Hurt Credit Rating

Standard & Poor's recently analyzed 101 mergers and acquisitions worth more than $5 billion since 2000 and found that these mergers and acquisitions can hurt credit ratings. In fact, 53 of the 101 transactions resulted in a credit rating that dropped at least one notch. Twenty one of the transactions resulted in no credit change and 27 resulted in a higher credit rating. The risks cited by S&P in the downgrades include weaker pro forma credit measures, reduced free cash flows, and increased business risk for the combined firm. It appears that many acquirers are borrowing too much in paying for acquisitions, at least according to S&P.

Trading At The Speed Of Light

What do the speed of light and stock trading have to do with each other? Actually, quite a lot. On September 18th, the Federal Reserve made an announcement that it would not scale back its support of the economy, an unexpected announcement. This type of news should move the market as a whole, and indeed it did. Looking at the chart below, taken from Yahoo! Finance, what time do you think the announcement was made public?

If you guessed 2 PM, you are correct. This chart shows that the announcement was a systematic event since the entire stock market moved, as well as the efficiency of the market in rapidly reflecting the new information.

However, several large trades made in Chicago are now under investigation. As you can read in the article, the Federal Reserve went to great lengths to ensure that the information was released to the market at exactly 2PM. Even with the Fed's safeguards, over $600 million dollars worth of assets traded in Chicago, all within 3 milliseconds after 2PM. Unfortunately, because of the physics related to the sped of light, it would have taken 7 milliseconds for the news to reach Chicago. In this case, it appears that someone in Chicago received the information early.

Case Study: Higher-Ed Textbook Publisher Cengage Files For Bankruptcy

Higher-ed publisher Cengage Learning, Inc., filed for a prepack bankruptcy yesterday. The company is the second-largest publisher of college-course material in the U.S., and it offers, among other products, books that at least attempt to compete with our favorite textbooks.

But things haven’t been going so well. For example, sales at Cengage "dis-Cengaged," dropping 18 percent for the six months prior to Dec. 31.

As is typical in a bankruptcy filing, Cengage lists creditors to whom it owes money. Two of the more notable include well-known economics textbook author Gregory Mankiw (owed $1.6 million) and finance textbook author Eugene Brigham (owed $474,000).

Cheap Debt, Increased Leverage

In 2012, 369 companies increased their net debt/EBITDA ratio. As a result, the median net debt/EBITDA ratio has increased to 2.43. As the article notes, bank loan covenants typically require this ratio to remain below 5.  Companies with a particularly high ratio include Hologic (6) and Molson Coors Brewing (5.4). Although some companies saw an increase in this ratio due to increasing debt on the balance sheet, a troublesome reason for the increase in the net debt/EBITDA ratio at several companies is a decrease in EBITDA. For example, Kraft Foods saw its revenue drop by 1.7 percent and Micron Technology saw a decrease in EBITDA of 41 percent.

1 + 1 = 3

Recently David Einhorn, the Greenlight Capital hedge fund manager, has suggested that Apple should issue preferred stock as a way of reducing the company's cash balance and increasing shareholder value. Einhorn argues that by giving the preferred stock to current shareholders, the market price of the preferred plus the new reduced price of the common stock (there would be a price drop since cash available to common shares would decrease) would be greater than the current stock price. In essence, Einhorn is arguing against M&M's pie model of the corporation. While we believe that excess cash does not create shareholder value, the idea that market participants can be fooled by adding preferred stock to a company's capital structure seems doubtful. 

Capital Structure: U.S Versus Europe

A major difference in the capital structure of U.S and European companies' balance sheets is the source of debt. European companies have traditionally relied heavily on bank debt rather than publicly traded debt. The total publicly traded debt of European companies is just 7 percent of GDP, compared to 35 percent in the U.S. With the recent banking turmoil in Europe, European banks have been deleveraging balance sheets. As a result, European companies have been issuing bonds in large amounts. For example, AB InBev issued $7.5 billion worth of bonds and Unilever issued $1 billion in bonds. Because of new banking regulations and economic problems, European banks are expected to shed $2 trillion over the next several years, which will likely increase corporate bond issues in Europe even further.