Ch 16 - FIN.pdf - LEARNING OBJECTIVES After studying this...

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After studying this chapter, you should understand: LO1 The effect of financial leverage. LO2 The impact of taxes and bankruptcy on capital structure choice. LO3 The essentials of the bankruptcy process. LEARNING OBJECTIVES 508 Cost of Capital and Long-Term Financial Policy PA R T 6 16 FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY WHAT DO PHARMACEUTICAL COMPANY GlaxoSmithKline PLC and satellite television provider DirecTV have in common? The answer is that, in May 2008, both companies announced bond issues. While part of GlaxoSmithKline’s $9 billion bond offering was for general corporate purposes, much of it was to be used to buy back the company’s stock. In DirecTV’s case, all of the proceeds from its $2.5 billion issue were to be used to buy back stock. Of course, these two companies were not alone in altering their balance sheets. In November 2007, retailer Target announced plans to issue new debt to buy back about $10 billion of its stock. Rating agencies frowned on the idea: Fitch downgraded Target’s debt, and Moody’s put the com- pany’s debt on watch for a potential downgrade. So why would companies like GlaxoSmithKline and DirecTV even consider borrowing money to repur- chase their own stock? And why would Target do so at the expense of a credit rating downgrade? To answer these questions, this chapter covers the basic ideas underlying optimal debt policies and how firms establish them. Thus far, we have taken the firm’s capital structure as given. Debt–equity ratios don’t just drop on firms from the sky, of course, so now it’s time to wonder where they come from. Going back to Chapter 1, recall that we refer to decisions about a firm’s debt–equity ratio as capital structure decisions. 1 For the most part, a firm can choose any capital structure it wants. If management so desired, a firm could issue some bonds and use the proceeds to buy back some stock, thereby increasing the debt–equity ratio. Alternatively, it could issue stock and use the money to pay off some debt, thereby reducing the debt–equity ratio. Activities such as these, which alter the firm’s existing capital structure, are called capital restructurings. In general, such restructurings take place whenever the firm substitutes one capital structure for another while leaving the firm’s assets unchanged. Because the assets of a firm are not directly affected by a capital restructuring, we can examine the firm’s capital structure decision separately from its other activities. This means 1 It is conventional to refer to decisions regarding debt and equity as capital structure decisions . However, the term financial structure decisions would be more accurate, and we use the terms interchangeably. Master the ability to solve problems in this chapter by using a spreadsheet. Access Excel Master on the student Web site www.mhhe.com/rwj.
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C H A P T E R 1 6 Financial Leverage and Capital Structure Policy 509 that a firm can consider capital restructuring decisions in isolation from its investment deci- sions. In this chapter, then, we will ignore investment decisions and focus on the long-term
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