Building Value with Capital Structure Strategies

Discover how a selected group of financial executives from eleven public companies, including Amgen Inc., General Electric Company, The Home Depot, and TELUS Corporation, as well as two private companies make their decisions about capital structure, dividends and related issues in this book. With findings based on interviews, case studies and financial theory, this must-have book will help you build a sound structure for your company's financial success.

From Chapter 1: Every CFO and treasurer pays attention to capital structure because it is integral to a company's strategy to build shareholder value, whether or not the company is publicly or privately held. Policies on capital structure and dividends vary widely. They are partly a matter of management choice but also are influenced by the nature of the company's business and current circumstances. For example, many companies increased their leverage in the 1980s, but many decreased it in the 1990s. Despite the importance of financial structure, relatively few recent articles in the business press address it directly and comprehensively. Through case studies, this research explores how a selected group of CFOs and treasurers make their decisions about capital structure, dividends, and related issues, and compares those findings with financial theory.

Research Methodology The researchers developed a comprehensive interview protocol and conducted on-site interviews with senior financial management of the participating case-study companies. Thirteen companies participated in the study, eleven of which are publicly traded and two which are privately held companies. To ensure that the case-study companies represented a variety of industries with different financial characteristics, the researchers developed a model to group the companies into four quadrants (referred to as the "quadrant model"), depending on whether their industries tended to have secular (i.e., more long-term) or volatile (i.e., cyclical) growth patterns and primarily fixed or intangible assets. Participating companies were also selected to represent a variety of other characteristics. Table 1 illustrates how the case-study companies mapped against that quadrant, recognizing that not every company fits perfectly into a specific quadrant. For example, Home Depot and Marriott International are fast-growing companies in industries that tend to operate cyclically.

PRINCIPAL FINDINGS AND LESSONS LEARNED
The 13 case studies in the full-length book provide detailed information about the guidelines that practicing managers use to make capital-structure decisions. The following section highlights the key findings of the case studies. A discussion of the financial theories that underlie these findings is presented in the sections, The Theoretical Background and The Role of High Debt.

How Capital-Structure Policies Vary
Using the quadrant model, the researchers discovered the following: the majority of case-study companies with secular revenue growth have low debt; the majority of companies with volatile revenue growth have moderate or high debt; the majority of fixed-asset companies have moderate or high debt; and the majority of the intangible-asset companies have low debt. The capital structures of the case-study companies, summarized below in table 2, vary from low debt to high debt, depending on factors such as cash-generating capability, growth opportunities, asset structure, industry cyclicality, and management risk tolerance.

Low-Debt Policies
For seven of the case-study companies, the flexibility and risk protection a conservative balance sheet provides is more important than the reduction in the cost of capital that would result from higher debt. Low-debt policies create the possibility that management's life is made easier at the expense of shareholders who might prefer higher risks and returns-the problem of agency costs, which is discussed in a later section, Debt's Effects on Agency Costs.

Home Depot and Paychex-currently low-debt companies-are the two case-studycompanies with the highest price-earnings ratios at the time of this study. They do not believe that taking on more debt to reduce their weighted average costs of capital would increase their value. They believe their share prices are based mainly on growth.

Moderate-Debt Policies
Georgia-Pacific, Marriott International, Monsanto, and TELUS maintain moderate levels of debt to lower their weighted average costs of capital which increases their corporate values as calculated on a discounted cash-flow basis.

High-Debt Policies
High debt, although not the norm for the majority of case-study companies, is appropriate for certain industries, such as hotel real-estate investment in the case of Host Marriott, and special situations, such as the Sheplers management buy-out and the Home Depot and Paychex start ups. A number of other studies summarized in the section on the role of high debt show that, for appropriate companies, management ownership combined with high leverage can provide both a carrot and a stick, resulting in superior financial performance. Many of the failures of highly leveraged companies in the late 1980s were caused by a combination of leverage carried too far and poor operating performance.

Private Companies' Debt Policies
The two private case-study companies, Sheplers and Vermeer, realize that external capital could help them accelerate their growth but would require them to change their company cultures and cede at least some control to outside parties. Sheplers allows that it never has been a debt-free company and never intends to be. However, management has confidence in the company's continued strong operating performance and has steadily paid down term debt. Vermeer has maintained a no-debt philosophy since its founding.

Fixed- and Floating-Rate Debt
In recent years, relatively low interest rates throughout the yield curve have encouraged companies to issue fixed-rate debt with the longest possible maturities. Some consider very-long-dated debt to have attractive pricing and equity-like characteristics.