Leverage and financing choices across capital-intensive industries

Finance

One difference between industries with high leverage and low leverage is a split between the need for fixed assets (high leverage) and a reliance on intellectual capital (low leverage). Airlines need planes, construction companies need equipment, and communications and hotel companies need infrastructure capacity. This compares with computers, drugs, biological products, educational services and electronics, all of which rely heavily on intellectual property to derive value. The conclusion that one can draw from this is that firms with a need for more fixed assets are more likely to borrow to acquire those assets. The borrowing can be long-term, to match the useful life of the fixed assets. Moreover, the interest and depreciation expenses can offset some of the costs of paying down that debt. Companies that are IP-intensive expense their research & development costs, making equity a more natural form of financing, as it tends to match up better in terms of duration than debt with intellectual property. In addition, these firms can pay for their R&D expenses through their operating cash flow -- there is no need for a massive up-front investment that would potentially necessitate taking on debt. Future earnings and taxes might lead fixed-asset firms to use debt as well, since they will benefit from interest payments. Further, they are able roll over debt for new major capital investments; it is harder to have a new equity issue every few years to finance expansion.

Question 2

Gordon's position has merit, but is perhaps not as practical as made out to be. Debt does lower the cost of capital, so if AT&T had more debt, it would have a lower cost of capital. The company would also increase its ROE with more debt. Further, the nature of AT&T's business is that it is oriented towards high levels of fixed investment, and firms with high levels of fixed assets usually have higher levels of leverage, to align repayments with cash flows from those assets. So in principle, Gordon's argument works. However, the nature of AT&T's business today is that constant reinvestment in R&D and fixed infrastructure is required. The need for massive amounts of capital year over year to fuel this investment means that AT&T should avoid debt for financing as best it can. The more money the firm has to plow into debt repayment, the less it will have to make the investments it needs to stay competitive. Prior to the digital age, Gordon's argument would make sense. But for AT&T to remain competitive in the digital age, the company benefits from having a higher level of retained earnings to plow into the rapid R&D cycle. If AT&T started piling up debt, it would affect its ability to remain competitive as its free cash flow would go to debt service instead of service improvement.

Ch 13, Closing Case

1. One of the implications for mutual fund investors is that sometimes actively managed funds perform well. Certainly, if one wishes to beat earn higher returns than the S&P, an actively-managed fund opens up that possibility.

2. The graph is not inconsistent with market efficiency. The funds might well have performed consistent with their risk levels. Earning a higher return than the S&P does not disprove efficient market hypothesis; earning a higher return on a risk-adjusted basis would. There is no evidence that the funds on the graph have the same risk or lower than the S&P 500. Further, performance against the market on a risk-adjusted basis is efficient over the long run. The sample size of time is too short to draw conclusions about the long-run performance of those funds.

3. The biggest equity decision to make with the 401(K) is how risky I want that portion to be. I could opt for the market risk, but given my investment horizon I might well opt for a riskier portfolio to seek higher long-run returns.

DQ1, Chapter 5, 6. Investors are seldom made whole with the "make whole" provision. A premium of 0.4% over Treasury is not consistent with the risk level of the firm. The YTM on the bond will reflect the actual credit quality of the bond, but ECY is not nearly large enough to have AAA credit, so the make whole provision does not apply a significant enough risk premium to the bonds -- the investors are not entirely made whole.

7. I would recommend regular coupon issue for a couple of reasons. The first is that the company raises more money in the short run, though it pays out more in interest down the road. However, regular coupon bonds are also more common and therefore have a bigger market. With greater liquidity, ECY can get a slightly better rate of return, since liquidity is a factor in the market price of bonds. I recommend the option that gives ECY more money up front and a bigger market for the issue -- regular coupon bonds. I recommend an ordinary call feature for the bonds. ECY would get more up front for the make whole provision, but there is less certainty with respect to future cash flows -- what it would cost to call the bonds down the road, since that would depend on the Treasury rate.

DQ 2, Chapter 20 Closing Case

5. The company should pursue international sales if these sales have a positive contribution margin. With the 0.73 exchange rate, the company's contribution is as follows:

Gross, €

5

less comm, €

-250000

Net Revenue, €

4750000

FX rate

0.73

Revenue, $

6506849

COGS

2555000

Operating Profit, $

3951849

With the 0.80 rate, the contribution is as follows:

Gross, €

5

less comm, €

-250000

Net Revenue, €

4750000

FX rate

0.8

Revenue, $

5937500

COGS

2555000

Operating Profit, $

3382500

The breakeven point is around $1.85/Euro, so if the company expects this rate to become reality, it should discontinue sales. As long as ECY believes that the Euro is going to remain above that level, it should continue sales in Europe because those sales are making a positive contribution to the company's fixed costs.