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Comments (23)

Jun 13, 2012 - 9:26am

you set up a template looking at different tranche of debt. usually the 20f or 10k has info on the security of the debt. if not, you can get a rough idea from the annual reports then try to get the indenture/credit agreement from your traders or bloomberg or cap iq and dig deeper into the ranking.

you will have to lay out metrics comparison like debt/ ebitda, net debt/ ebitda, price, covenant (negative or financial, current yield, ytm, etc, depending on the metrics you want to look at.

Jun 13, 2012 - 9:50am

depends on what you're trying to achieve and what your perspective is (e.g. equity or debt, control or participation)

"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
Jun 13, 2012 - 5:10pm
terminator:
Thanks for the useful information. I am doing it more for equity research report purposes. My team's analysis wasn't as good as the other teams. I thought one of the issues was our lack of focus on the capital structure. Hence, why we need a proper framework. So the lbo model isn't very useful for it? Otherwise, I was planning on self-studying how to do it.

With an LBO model you'd be wiping out the old cap structure and putting in your new one so not a good way to look at it. From an equity perspective you'd want to look at maturity walls, interest burden ratios (think your DuPont ROE calc.), diversification of the debt base, covenant headroom (i.e restricting imminent) and determine if it is the most efficient way of funding the business e.g. is it worth having higher cost of debt of bonds for the marginal freedom from lesser covenants / increased freedom over bank debt? or having a massive RCF sitting there taking up commitment fees is useless unless you want it for something such as acquisition (or you got it cheap) etc.., . I'm not an equity guy but yea, my input

in addition you'd want to look at the lock up ratio covenants to see when you can get a dividend.

"After you work on Wall Street it’s a choice, would you rather work at McDonalds or on the sell-side? I would choose McDonalds over the sell-side.” - David Tepper
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Best Response
Jun 13, 2012 - 5:07pm

Ricqles is spot on - line out each tranche of debt line by line with face amount by seniority and then by maturity. Columns should include date issued, maturity, interest, when payable (quarterly/semi), what is the revolver capacity/draw, and you should note total liquidity somewhere (cash plus revolver available). Note very specifically what the interest rates are, whether floating or fixed, and to what benchmarks (EURIBOR, LIBOR, Prime, etc.). A nice little touch is to put 'cumulative leverage' in one column so you can see as you layer on each tranche what it does to leverage - e.g. this co is 3.5x levered through the senior secured, 7x total. It's also important in some cases to note which sub issues/guarantees the debt, some cos will issue at foreign subs for foreign assets and this can lead to double dip scenarios.

if you like it then you shoulda put a banana on it
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Jun 13, 2012 - 5:11pm

Reaching optimal capital structure (Originally Posted: 10/04/2010)

Hi guys,

A couple of questions:

  1. How can you tell how far from optimal capital structure a firm is? What ratios could you use to compare your firm to other firms to determine this?

  2. If you thought you had too much debt, how would you increase equity and decrease debt? Issue equity and use the cash to buy back debt? What are the costs of this?

  3. If you thought you had too much equity, how would you decrease equity and increase debt? Issue debt and use the proceeds to buy back shares? Again, what are the transaction costs?

  4. Are these sorts of transactions the job of the investment banker? What sort of fees would these raise?

Thanks

Jun 13, 2012 - 5:13pm

There is an optimal capital structure. Every BB has a group that does that.
1.
One way of doing it is finding a quantitative representation of the credit rating from the relevant metrics, these are usually size and leverage, implied from some kind of an industry average.
You'll then need some kind of a historical estimate on how changes in credit rating are associated with changes in firm value (i.e. if you lose access to commercial paper, or move below investment grade, there is a statistically significant decrease in FV). Specific approaches are proprietary to every bank, as there is no "hard" academic view on doing it correctly.

Once you have these numbers, you may (for example) run a simulation that gives you a curve of Firm Value versus Debt/EBITDA, which would be concave with a unique point of maximum FV.

Yes, i-bankers are normally responsible for it and the associated fees are the potential debt/equity offerings. Though pure "advice" on optimal leverage in itself is usually free

Jun 13, 2012 - 5:14pm

Capital Structure Question - Elaborate responses? (Originally Posted: 03/06/2008)

My friend received this in an interview, I'm not sure how to best answer this:

"What factors contribute how to determine the optimal capital structure of a firm? What are the benefits of each?"

-I would talk about the risk/cost that come with debt and equity. But, I would like to hear more elaborate responses.

Thank you.

Jun 13, 2012 - 5:15pm

Think about relaxing the assumptions of MM theory and then see how they individually affect the capital structure of a firm. This answer is much more theoretical than practical.
In a MM world, financing with debt or equity makes no difference. Taxes always play a role in the capital structure you choose, so do bankruptcy costs, incentives for the entrepreneur(firm leaders), and assymetric information. The reasons these affect capital structure can be found in a finance textbook. The pecking order theory may also be useful in the conversation but really only applies when a company needs to finance a new project.

If you want a more practical answer, ask someone who is already working, I won't really know until the fall.

Jun 13, 2012 - 5:16pm

Yeah, def. agree with the poster above. I would've said something like "In a perfect capital market, structure is irrelevant. But given that we obviously don't have one of those, there are a few things that companies can look at. With taxes present, adding leverage increases the value of the firm, because it increases the amount that the firm can write-off of its taxes. Thinking this way, it would be optimal for a company to be fully levered. However, there are also costs of financial distress (restructuring charges, lost business, etc) that pull down the value of the firm once leverage gets above its optimal level. If analysts can predict T* (the net benefit to leverage) relative to firm value and leverage, then they can use that equation to find L* (the optimal leverage ratio) by taking its first derivative (as the value of the firm is maximized when T*'=0)."

 

Jun 13, 2012 - 5:17pm

Great answers from the posters above.

In an interview, the interviewer is trying to see if you understand the basics about WACC and the differences of cost of equity and cost of debt. Don't go too deep unless you're asked to. For most industries the optimal capital strucutre is achevied around a BB+ rating.

Your cost of debt increases as you increase leverage. For example, a company like Microsoft with no debt, can easily raise large sums of funds in the commercial paper market at around 2.7%. After factoring in a tax rate of 35% (effective tax rate should be lower) the effective cost of debt drops to 1.75%. If I were to buy a share of MSFT, I would expect to make more than 1.75% (through dividends and share appreciation). Debt for MSFT is much cheaper than equity. Once you become very levered, debtholders want a higher and higher interest rate, and soon issuing equity becomes cheaper.

In addition to cost, there is flexibility available with each product. Cash outflows from equity are more flexible than coupon payments on debt. Although companies generally have sticky dividends, they choose when to provide special dividends and share buybacks to return cash to shareholders.

Bankruptcy costs and franchise valus destruction are factors that I really didn't consider before I started working. Bankruptcy is expensive. Think about all those lawyers. Think about all the value in a company you destory in bankruptcy. As you increase debt, you increase the value of bankruptcy, and you should factor in that cost into your captial structure analysis.

You would also want to consider off-balance sheet debt/contractual obligations. Leases are very similar to debt. You need to pay a fixed amount every month/quarter for a period of x years. Sounds like debt. Off-balance sheet financing vehicles are off-balance sheet, but it really is debt of the company that should be factored into capital structure calculations.

Jun 13, 2012 - 5:18pm

Suggested Readings on Capital Structure? (Originally Posted: 05/07/2015)

As a non-finance major, I didn't do too much (cough any cough) reading on capital structure in school.

Do you monkeys have any suggested readings on the topic?

Jun 13, 2012 - 5:19pm

The Baker and Martin book is decent and I used it for reference during UG.

I wouldn't say you need a book on cap structure and you can find a lot of resources online. Just make sure you don't confuse the theoretical/academic stuff with real life applicability. My textbooks had a tendency to dive in with the MM propositions/capital structure irrelevance followed by shit with disproves it. Although it doesn't give you a good foundation.

Jun 13, 2012 - 5:20pm

There's a chapter [Chapter 7] in Moyer's distressed debt analysis that discusses capital structure. This is more from an investor perspective and focused on details of how risk is distributed, than a general overview of capital structure from a corporation's perspective.

Jun 13, 2012 - 5:21pm

Capital Structure Question - Trying to figure out a target for capital structure (Originally Posted: 02/27/2013)

So I am trying to figure out a target for capital structure for an assignment. When analyzing debt i was wondering if i should include two extra categories, Long-term capital lease obligations and Long-term financing lease obligations.

Should I count these two areas in the Market Value of Debt? The Company that I am doing this project on is Amazon.

Jun 13, 2012 - 5:23pm

I always look at the industry the company would fit in and take a look at the industry WACC. That gives me an idea of where the debt should be, this would confirm that I am not totally off. Very close competitors, the closer the better finance in similar ways. The key is to determine the closet competitors even if you only find two or three, if they are very close to your company, you should be able to confirm that you are on the right path with weights of equity and debt.

Jun 13, 2012 - 5:24pm

Capital structure in VC (Originally Posted: 01/06/2015)

Hello,

I've some doubts about how much of the company is sold during a capitalization. How is decided whether it will be 10, 25 or 90%?

Could anyone quote some readings about capital structuring?

Jun 13, 2012 - 5:25pm

It typically varies by stage. We've recently seen the % of the company sold to investors in a round of VC financing come down due to the amount of money being in invested (and wanting to be invested) in the space. You'll often see somewhere between 10-20% equity taken per round around the earlier stages (till series C or so). From there the numbers can fall below 10% as investors could be putting in $100M at a $1B+ valuation.

Required reading for VC investments, term sheets, etc. is Venture Deals by Brad Feld.

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