General Motors Bankruptcy Statement

 

 

FOR RELEASE: 2009-06-01

GM ANNOUNCES AGREEMENT WITH U.S. TREASURY AND CANADIAN GOVERNMENTS PROVIDING FAST TRACK TO COMPETITIVE FUTURE FOR 'NEW GM'

NEW GM, BUILT FROM COMPANY'S STRONGEST OPERATIONS, EXPECTED TO LAUNCH IN 60-90 DAYS UNDER NEW OWNERSHIP

GM FILES VOLUNTARY CHAPTER 11 TO IMPLEMENT '363' SALE AGREEMENT

GM IS OPEN FOR BUSINESS IN THE U.S. AND WORLDWIDE, HONORING ALL CUSTOMER COMMITMENTS

• Warranty, service and customer support continue uninterrupted, backed by the U.S. and Canadian governments
• Essential suppliers to be paid in the normal course
• Employees to be paid in the normal course
• Operations outside U.S. not included in court filing

DETROIT, June 1, 2009 - General Motors (GM: 27.80, -0.02, -0.07%) today announced that it has reached agreements with the U.S. Treasury and the governments of Canada and Ontario to accelerate its reinvention and create a leaner, stronger "New GM" positioned for a profitable, self-sustaining and competitive future.

Pending approvals, the New GM is expected to launch in about 60 to 90 days as a separate and independent company from the current GM ("GM"), with two distinct advantages: it will be built from only GM's best brands and operations, and it will be supported by a stronger balance sheet due to a significantly lower debt burden and operating cost structure than before. The New GM will incorporate the terms of GM's recent agreements with the United Auto Workers (UAW) and Canadian Auto Workers (CAW) unions and will be led by GM's current management team.

The New GM will execute the key elements of its April 27 viability plan, along with additional initiatives, to achieve winning financial results by putting customers first, concentrating on adding to the company's line of award-winning cars and trucks through four core brands and continuing to invest in green, energy-saving technologies.

Under its plan, GM will sell substantially all of its global assets to the New GM. To implement the sale agreement, GM and three domestic subsidiaries have filed voluntary petitions for relief under chapter 11 of the United States Bankruptcy Code in the U.S. Bankruptcy Court for the Southern District of New York, and the sale is subject to the approval of the Court. Because GM's sale of assets to the New GM already has the support of the U.S. Treasury, the UAW and a substantial portion of GM's unsecured bondholders, GM expects the sale to be approved and consummated expeditiously.

GM has asked the Court to approve a number of steps to protect current and new GM customers, ensure that its operations will continue uninterrupted during the court-supervised process, and provide for a smooth transition to the New GM.

"Today marks a defining moment in the reinvention of GM as a leaner, more customer-focused, and more cost-competitive company that, above all, can quickly generate winning bottom line results," said Fritz Henderson, GM president and CEO. "The economic crisis has caused enormous disruption in the auto industry, but with it has come the opportunity for us to reinvent our business. We are going to do it once and do it right. The court-supervised process we are pursuing provides us with powerful tools to accelerate and complete our reinvention, as well as strong safeguards for our customers and our business. We are focused on the job at hand, for the benefit of our customers, employees, dealers, suppliers, retirees, taxpayers, investors and other stakeholders.

"We recognize the sacrifices that so many have been asked to make as we have worked to reinvent GM and the automobile," said Henderson. "GM deeply appreciates the support and the demonstration of confidence in our future by President Obama, the Presidential Task Force on Autos, the Canadian and Ontario governments, American and Canadian taxpayers, the unsecured bondholders who are supporting the proposed sale transaction, the UAW and CAW and their leadership, and the men and women of GM, including our retirees. You have enabled us to carry out this vital transformation for the good of GM, our customers and the economy, and we are working to validate your trust each day.

"From day one, the New GM will be well-positioned to capitalize on the award-winning vehicles we have developed and launched during the past few years, and on our investments in exciting new technologies like the Chevy Volt, so that we can build and return value to our customers and to the millions who will have a stake in our success. The New GM will play a critical role in the future of the automobile, and assure that the U.S. has a strong stake in this rapidly changing global manufacturing industry," Henderson said.

Business operations continue globally without interruption

GM's North American manufacturing operations continues to monitor production output to make sure it aligns with market demand, and currently intends to ramp up manufacturing operations as market demand improves during the latter half of the year.

None of GM's operations outside of the U.S. are included in the U.S. court filings or court-supervised process, and these filings have no direct legal impact on GM's plans and operations outside the U.S. GM confirmed that all business operations are continuing without interruption in its Europe; Latin America, Africa and the Middle East; and Asia Pacific regions.

"Worldwide, GM dealers are open for business, offering competitive financing options on our award-winning vehicles, continuing to honor our industry-leading warranty coverage, and providing outstanding service," said Henderson. "Furthermore, the U.S. Treasury and the Canadian governments have issued a strong vote of confidence by backing GM's vehicle warranties."

GM has filed various "first day" motions with the Court to ensure the company's continued ability to conduct normal business operations. Upon Court approval, GM will be expressly authorized, among other things, to:

The New GM

GM's agreements with the U.S. Treasury, the Canadian and Ontario governments and the UAW and CAW, in addition to the support of a substantial portion of GM's unsecured bondholders, will enable the New GM to be a leaner, faster and more customer-focused enterprise, consistent with the vision, goals and plans of GM's enhanced operating plan announced April 27.

The New GM will:

Capital Structure of the New GM

A critical element of GM's reinvention is to achieve a significantly stronger and healthier balance sheet. On March 31, 2009, GM reported consolidated debt of $54.4 billion, along with additional liabilities, including an estimated $20 billion obligation to the UAW VEBA.

Under GM's agreements with the U.S. Treasury, the Canadian and Ontario governments, and the UAW and CAW, and with the support of a substantial portion of GM's unsecured bondholders, upon closing of GM's sale of assets to the New GM, the New GM's capital structure will be comprised of:

Other than the $8 billion of debt owed to the U.S. Treasury and the Canadian and Ontario governments by the New GM, all amounts owed by GM or the New GM to the U.S. Treasury and Canadian and Ontario governments would be equitized in exchange for the New GM securities described above, and no other debt will be owed by GM to the U.S. Treasury and the Canadian and Ontario governments.

GM Europe Restructuring

GM announced separately today, GM Europe has an agreement for 1.5 billion of bridge financing from the German government and a Memorandum of Understanding to partner with Magna International Inc. Under the agreement, the Opel/Vauxhall assets have been pooled under Adam Opel GmbH, with the majority of the shares of Adam Opel GmbH being put into an independent trust (the balance to remain with General Motors), while final negotiations with Magna proceed. Negotiations to close the agreement should take several weeks. Additional details will be available athttp://media.gm.com/eur/gm/en/.

New products and technologies on track

The New GM, with its strong financial base and best-in-class dealer network, will support a portfolio of award-winning vehicles, including the Chevy Malibu (2008 North American Car of the Year and J.D. Power and Associates' segment leader in its 2008 Initial Quality Survey), Cadillac CTS (Motor Trend Car of the Year) and its Buick brand (tied for 1. The New GM will have a number of key vehicle launches in 2009 and 2010, including:

"Our products are our future, and our lineup of new cars and crossovers are a great foundation for success," said Henderson. "The New GM is here to stay, and our brands position us to compete well in profitable segments with vehicles that are second-to-none."

GM also reaffirmed its commitment to improve the fuel efficiency of its vehicle fleet, meet or exceed new federal fuel economy and emissions regulations, and push ahead with advanced propulsion technology. GM will launch the Chevrolet Volt extended range electric vehicle in 2010, expects to have 14 hybrid models in production by 2012, and will have 65 percent of vehicles alternative-fuel capable by 2014.

"The New GM will become a long-term global leader in the development of fuel-efficient and advanced-technology vehicles," said Henderson. "In doing so, the New GM will contribute to the development of advanced engineering and manufacturing capabilities in the United States, which are critical to the future of the U.S. economy."

GM's primary bankruptcy counsel is Weil, Gotshal & Manges LLP. GM is also represented by Jenner & Block LLP and Honigman Miller Schwartz and Cohn LLP as counsels. Cravath, Swaine, & Moore LLP is providing legal advice to the GM Board of Directors. GM's restructuring advisor is AP Services LLP and its financial advisors are Morgan Stanley, Evercore Partners and the Blackstone Group LLP.

More information about GM's chapter 11 cases is available atwww.GM.com/restructuring.

Court filings and claims information are available at www.GMcourtdocs.com.

About GM
General Motors Corp. (NYSE: GM), one of the world's largest automakers, was founded in 1908, and today manufactures cars and trucks in 34 countries. With its global headquarters in Detroit, GM employs 234,500 people in every major region of the world, and sells and services vehicles in some 140 countries. In 2008, GM sold 8.35 million cars and trucks globally under the following brands: Buick, Cadillac, Chevrolet, GMC, GM Daewoo, Holden, Hummer, Opel, Pontiac, Saab, Saturn, Vauxhall and Wuling. GM's largest national market is the U.S., followed by China, Brazil, the United Kingdom, Canada, Russia and Germany. GM's OnStar subsidiary is the industry leader in vehicle safety, security and information services. More information on GM can be found at www.gm.com.

Forward Looking Language

This news release and management's comments on it contain "forward-looking statements." These statements are based on GM management's current expectations and assumptions, and as such involve a number of risks, uncertainties and other factors that could cause actual results to differ materially from those that we now anticipate -- both in connection with the Chapter 11 filings we are announcing today and GM's business and financial prospects. Those risks are described in GM's Annual Report on Form 10-K for the fiscal year ended December 31, 2008 which was filed March 5, 2009, GM's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2009 which was filed on May 8, 2009, GM's Current Report on Form 8-K filed on May 14, 2009 and other GM filings with the Securities and Exchange Commission.

Case Study: GM and the Great Automation Solution

 

"Automation came along just in time to save us." —Roger Smith, 1980

Summary
General Motors has sat at or near the top of the Fortune 500 for decades. Populated by such legendary management figures as William Durant, who created GM by consolidating dozens of smaller carmakers, and Alfred Sloan, the man responsible for GM's modern decentralized structure and broad product line, GM dominated the automobile industry. Over time, in the face of competitive threats by foreign carmakers and changes in industry dynamics, the dominant company struggled. When Roger Smith became CEO, he set out to transform the company, shoveling billions of dollars into factory automation in an attempt to cut labor costs and catch up to the Japanese. When the dust settled, GM's market share had slid from 48% to 36% during Smith's tenure, a slide that has continued to the present day when GM's share comes in under 30%.

This is the story of GM's quest for supremacy by replacing people with robotics, what gave rise to this strategy, and why it was ill conceived from the very start. While Roger Smith deserves criticism for embracing the automation solution without really understanding its limitations, the story is also one of ineffective organizational learning and failed corporate governance. The lessons that emerge from an analysis of a near-$45 billion investment strategy hold resonance today as much as they did in the 1980s.

"General Motors was the model for industrial organizations of the 20th century: powerful, stubborn, monolithic and authoritarian, its prosperity based on the relentless march of its assembly lines."

Early Days at GM: The Seeds of Success
In 1892 a man named R. Olds invested his lifesavings to create the Olds Motor Vehicle Company to build horseless carriages, known as automobiles. Olds founded the first American factory in Detroit devoted to automobiles and was soon followed by several other companies making cars in the Detroit area. By 1903 the industry was consolidating and Olds merged with William Durant's Buick Motor; the new entity was called General Motors. Under Durant's leadership, a wave of acquisitions followed, including Cadillac and Oakland (renamed Pontiac) in 1909, and Chevrolet in 1918. When the deal making was done two years later, the modern GM had been created—a giant amalgamation of over 30 different companies.

With infrastructure in place, GM took aim at the Ford empire created by Henry Ford and his Model T. Having pioneered the assembly line that enabled mass manufacturing, Ford was the dominant force in the early automotive era and the competitor to beat. It took another giant—legendary GM CEO Alfred Sloan—to make that happen. Considered the most influential CEO in GM's history as well as a pillar in business history, his slogan, "A car for every purse and purpose," became GM's trademark. Sloan recognized that GM could not compete on price alone, so his strategy was to sell cars at the top of each price range, competing in quality against less-expensive cars and in price against higher-quality cars. With this came his theory of "planned obsolescence," where the concept of annual models was rolled out. Sloan visualized an emerging market for repeat sales if a car could be perceived as out-of-date within four to five years. He also introduced a reorganization philosophy, creating the famous GM Management System of decentralized operations and responsibilities with coordinated controls. Each division retained a high degree of autonomy while a central GM board set uniform policies and guidelines. The result: by the end of the 1920s, GM was overtaking Ford, and by the 1940s, a GM nameplate was on almost one out of every two cars sold in America. GM became the first corporation in the world by 1955 to generate $1 billion in revenue in a single year. After growing GM into one of the most successful corporations in American history, Sloan retired the following April.

The Changing Landscape
Few organizations in American industry have had the long-term success that GM enjoyed. It was the industry's low-cost producer, with powerful economies of scale and market share as high as 60%. For a long time only the threat of Justice Department action to shrink the company's market dominance clouded the picture.

While GM prospered for years, problems were beginning to brew under the surface. Although U.S. demand for cars increased after WWII, European manufacturers were beginning to make an impact. In 1956, for example, Ford and GM lost 15% in sales while imports doubled their market penetration, and even worse, the following year the U.S. actually imported more cars than it exported. By 1956, GM's market share for new car sales fell to 42%.

Over time, other pressures arose. The tumultuous 1960s brought growing urban poverty and riots in Detroit. The nascent environmental movement focused attention on pollution and, by 1974, GM was spending $2.25 billion to meet pollution regulations, with that figure doubling by the end of the decade. To top it off, the OPEC oil embargo drastically decreased demand for GM's luxury, gas-guzzling cars. While GM introduced smaller cars, the market dwindled in the late 1970s as the U.S. plunged into recession. Into this environment—with GM recording only its second year of losses in its long history—Roger Smith became Chairman and CEO in 1981, bringing with him a confident vision to carry GM back to its glory days.

"In those days, the question was 'how many robots do you have?'"

The Robot Revolution
In the early 1980s another foreign competitor, the Japanese, exploded onto the U.S. auto market, offering reliable, small, competitively priced cars. The Japanese approach, which emphasized such unusual (for GM) practices as just-in-time inventory, quality management, painstaking attention to production processes, extensive employee training and involvement, and close cooperation with suppliers, generated productivity rates far in excess of anything Detroit could muster and posed a real threat to the established order in automobiles. To deal with the growing global assault and reestablish its domestic leadership, GM unleashed a radical business plan to automate and modernize its factories as well as its car models. It was not a subtle strategy—the centerpiece of the plan was to substitute high-tech robotics for inefficient labor, relying on GM's huge financial resources to make it all work. The estimated cost—$40-45 billion—was 14 times Ford's annual pretax earnings at the time. Because Smith believed robots could "do anything," the bulk of the capital expenditure was spent on factory automation, including the latest technology in advanced computer services, microelectronics, and systems engineering. The brand new, automated factories would, in theory, produce fuel-saving, smaller cars of the highest quality in greater volume and more cheaply than the competition. "In one masterstroke, GM would stop the import invasion cold and leave the competition years behind."

In line with the revolutionary transition to automation, GM also announced the most widespread reorganization since the consolidation days of the 1920s. Two manufacturing fiefdoms—Fisher Body and the GM Assembly Division—were abolished and control of production was placed under two newly created operating divisions. To break down silos across functional areas, each division would control design, manufacturing, and sales.

The changes at GM spearheaded by Roger Smith elevated him to the status of press darling in the first half of the 1980s. With 85% of the reorganization efforts based in the U.S., Smith became a champion of U.S. manufacturing, catching the public's imagination, and becoming a media hero. Described as an "innovator," "visionary," and "21st century futurist," Smith was named Automotive Industries Man of the Year and Advertising Age's Ad Man of the Year, honored with the Financial World Gold Medal (best CEO in America), and designated by The Gallagher Report as one of the ten best executives in America. With such acclimation, it seems little wonder that "GM completed the 1980s in a state of arrogance."

GM's Sting: Money for Nothing
Though confidence remained high, productivity paybacks from GM's factory automation spending seemed slower-than-expected right from the start. Costs were rising at an alarming rate while market share and operating income were starting to decline, a combination that might trigger warning bells in some organizations. Internal GM reports indicated that by 1985 the Japanese cost advantage had not changed after four years of intensive spending on automation. The company that was founded on the principle of cost savings and was once the prototype for efficiency had by 1986 become the auto industry's high cost producer. The average number of autos produced by each GM employee stood at 11.7, while the same metric at Ford was 16.1 and as high as 57.7 at Toyota. GM also earned 38% less than Ford and 26% less than Toyota on each vehicle they made. Research by Marvin Lieberman and Rajeev Dhawan of UCLA, who studied productivity trends in the auto industry from the mid-1960s to the 1990s, confirm the story: GM's plant productivity, which had lagged Toyota's for years, actually declined further from 1984 to 1991, a period that should have reflected the gains from GM's automation push.

The new automated factories, which made over two-thirds of the parts used in GM cars, had become a high-cost problem, hardly more efficient than the old ones. Some plants were running at 50% capacity because of glitches in computer-integrated systems, while two major strikes in the U.S. and Canada in mid 1980s spoke to the state of labor relations during these changes. GM's share of U.S. auto sales fell to 41% in 1986 , while the company's stock price increased 35% from 1981 to 1987, a duration when Ford's market value increased seven-fold.

Former GM CFO F. Alan Smith summed up GM's situation in 1986:
"Since 1980 GM has spent $45 billion on the automotive business. Capital spending appears to be almost inversely related to our levels of operating profit. And GM's forward capital spending plans are projected to be $34.7 billion over the period from 1986 through 1989. For $34.7 billion, given recent market valuations, GM could have purchased Toyota and Nissan. This would almost double GM's world market share, increasing our penetration to over 40% of the entire free world. Can we expect to double our worldwide market share from our spending program?"

Automating GM—The Key Lessons
The strategy to automate General Motors in the 1980s under Roger Smith was predicated on a false assumption—that replacing people with machines could turn back the Japanese attack and bring GM back to dominance in the global auto industry. Rather than adopt the lean manufacturing techniques that still define the Toyota production system today, a virtual obsession with robotics took over. In some ways this was no different than the companies today that jump on the latest fad without really understanding the underlying processes and inter-relationships that make the whole thing work. That was certainly the case with GM and automation in the 1980s. By not understanding how people and machines could be effectively integrated, GM missed the essence of Toyota's low-cost production success. Former Ford President Phil Benton put it this way: "Automation would not make the list of major problems facing the auto industry in the 1980s." Consistency of manufacture must come before automation. Toyota is not as automated as Nissan, for example, but they are more successful. "Everything goes back to management. What you need to do is engineer the product to the skills of your work force."

The Japanese also excelled at the other fundamental components of lean manufacturing, including just-in-time inventory, supply chain integration, and quality management. "[Automation] didn't save the company very much because GM still needed people," explained Charles McElyea, a factory automation engineer. By simply using the technology without the prepared workforce, "all you can do is to automate confusion." Robert Lutz, someone who has witnessed first-hand many of the changes in the auto industry over the years as a senior executive at GM, Chrysler, and most recently Ford, gave this assessment:
"The thought was if we can do a fully automated factory and get rid of all the labor, we would have plants that run day and night fully automatically. But with these totally automated facilities you lose all flexibility and they are extremely capital intensive. The only way you can hope to make a return is to run pedal to the metal at all times. They were prisoners of the great North American manufacturing cost accounting system that says, as you eliminate labor, your costs goes down. But what they forgot was they were getting rid of direct labor but replacing it with indirect labor and huge capital costs. These costs were high because the technicians and other people needed in an automated plant were much more expensive than the hourly laborer. You need to look at every worker. You look at his value added time versus his wait time and you arrange the production flow in such a way that you maximize the value added time of each worker and reduce the waiting time. You concentrate on the worker not on the machinery. Use automation only where necessary".

At its core, the automation strategy drew its genesis from Roger Smith's business and personal beliefs. Despite internal opposition, it was Smith—described by many as autocratic Ðwho defined GM's problems in the 1980s in terms of labor costs. To his credit, Smith also understood that GM's slow, bureaucratic culture was a hindrance to change, and his push for new organizational structures, the attempted infusion of EDS entrepreneurialism to GM, and investments in NUMMI (the joint venture with Toyota) and Saturn were all attempts to shake up that culture. But his focus on high-technology solutions to the labor cost problem underlined his belief that costs could be cut by replacing people with machines. He browbeat the UAW with statements like, "Every time you ask for another dollar in wages, a thousand more robots start looking more practical", and was described by one insider as "fascinated with anything new and high-tech; he really doesn't understand, or want to hear about, the limitations of technology." To his critics, he was an "unusual man who just doesn't understand people"

The GM Board of Directors
Where was the GM board during this time, and do they deserve some of the responsibility for the automation debacle? Roger Smith became infatuated with robotics and began to see it as GM's salvation right from the start. While there was internal opposition, particularly among people who understood that productivity is not just based on labor costs but on the entire production system, the board of directors appears to have had little problem with the strategy. Indeed, given the deteriorating state of GM labor relations and productivity at the beginning of the 1980s, turning to the automation solution may well have been considered reasonable. It didn't take long, however, for problems to develop. Plant efficiency was down in many factories, productivity improvements relative to the Japanese did not materialize, and traditional metrics like stock price and market share reflected these problems. Further, when a company spends some $45 billion on automated factories, it does not write a single check for that amount and wait for delivery. Expenditures of this magnitude involve thousands of checks written to vendors over a long time period, with an opportunity to assess progress along the way. For example, in 1983 GM spent $6 billion for new technology and automation, increasing to $9 billion in 1984 and $10 billion in 1985. Even by 1985, when internal studies were indicating little change in the productivity gap between GM and Toyota, GM was still poised to spend more. Nevertheless, throughout this time the board of directors continued to approve Roger Smith's plans and expenditures. Why?

Much has been written about the classic warning signs in corporate governance, and all are in evidence here. Almost one-quarter of the board consisted of GM insiders in 1982, rising to as much as 41% by 1986. Outsiders did not have much of a personal stake in the company, with three out of five owning less than 1000 shares of GM stock. Along with the undoubted prestige that comes with being a GM director, the generally advanced age of outsiders on the board (8 outsiders were actually retired from their former corporate jobs), and the heavy time commitments of virtually all the outsiders on other corporate and non-profit affiliations (averaging around 8 such commitments for each board member during this period), the odds were stacked against the GM board taking an activist stance in monitoring Roger Smith and his automation program.

In addition to these traditional indicators of board independence, there is some evidence and inference that Roger Smith had significant control over the board. Board meetings were known as formal, with little open and honest discussion. Inside board members would not speak unless specifically charged with giving an informational report to the board. As one retired board member said, "unanimity on this board is assumed". When Ross Perot was on the GM board for a few years in the mid-1980s following the acquisition of his EDS, he referred to Smith's optimistic predictions as "gorilla dust", designed to throw off criticism as much as anything else.

Contributing to the unquestioning environment was the remarkable extent to which board members' formal positions were intertwined. Whether by design or circumstance, virtually every single outside board member at GM had another formal appointment—whether on another corporate board or non-profit organization—in common with a colleague on the GM board. In 1982, for example, (whose composition was not only representative of, but almost unchanged from, the GM board in subsequent years), two different GM directors also sat on the boards of US Steel, Dart & Kraft, Merck, and International Paper. Three different GM board members were also directors of AT&T, Nabisco Brands, Citicorp, and Kodak, and four GM directors were present or former board members of JP Morgan. Ten GM directors were on the Business Council, six on the Business Roundtable, four were directors of the United Negro College Fund (the Chairman of the Board was a GM insider), and two different GM board members were affiliated with governance of the Mayo Foundation, New York Hospital, and the Sloan-Kettering Cancer Center. Overall, the extent of overlapping affiliations and directorships is nothing short of spectacular, and may well have been a contributor to the non-critical culture in place at the GM board. Under this arrangement, in the event a member of the GM board chose to speak out or break the norm of "unanimity", any potential retribution could not be easily contained within this one organization.

In sum, the robotics strategy that Roger Smith and General Motors adopted in the 1980s stands as a classic story of misreading the competitive landscape. For Smith, robotics represented the Holy Grail, the perfect strategy that could solve all of GM's problems at once. When GM finally discovered that the Holy Grail didn't exist, they could look back on an incredible waste of resources. Roger Smith was a very smart executive who failed, because of his own badly mistaken perception of the auto industry, a culture (that he helped engender) at GM that was afraid to ask questions, and a board of directors that watched billions of dollars go out the door with apparently little concern.

What Is the Relationship Between Capital Structure and Performance?

Capital structure and performance are two business concepts that often relate closely to a company’s corporate finance department. Capital structure represents the mix of debt and equity financing a company uses to pay for large parts of business operations. Performance is often a review of how well a company meets goals and other measurements it has defined for itself. The relationship between capital structure and performance often comes when a company wants to ensure they are not paying too much for the use of external funds. This review typically involves the cost of capital paid for a mix of outside financing, which is the aggregate interest rate paid for these funds.

Large companies and organizations are typically the institutions that use a mix of debt and equity financing types. Debt can be both bank loans and bonds issued by the firm, though other debt types may be included here. Equity is usually stock offerings made to financial institutions; some equity investments made directly by an equity firm may also go here. Like all borrowed money or stock issued, companies must pay some form of interest or financial returns on these funds. Each type of money used from an external source has an attached interest rate, which is essentially the cost to use someone else’s money, again linking capital structure and performance.

Corporate finance departments tend to heavily evaluate each type of project or other investment that requires outside funds. Financial formulas can help a company decide which type of outside funds to use based on interest rates and the length of the repayment terms for these funds. Capital structure and performance is important because small changes in the structure can result in major shifts relating to the outcomes of each project. In some cases, a single project may actually require an individual mix of bonds, debt, or equity funds in order to pay for it. Companies must ensure that each of these items added to the current capital structure does not create financial hardship on the business.

Failing to recognize the relationship of capital structure and performance on internal finances and a company’s financial statements can be devastating. First, a company can experience low cash flows for an extended time period, making it difficult to pay bills. Second, a heavy debt load on a company’s balance sheet can result in less interest from future investors or lenders. Third, more pressure is on the company to perform well, which can create undue pressure on those within a business to fudge numbers or engage in fraudulent activities. Finally, companies may be subject to more external reviews from outside regulators.

What Are the Determinants of Capital Structure?

Any type of organization or entity, whether a corporation or a nation, relies on capital to facilitate its operations and achieve it core functions. How the organization structures its capital will often determine the efficiency in which it is able to leverage that capital to accomplish its goals. Capital structure in an organization thus refers to the ratio of both debt and equity that comprise those capital resources. Central to analyzing capital structure is the ratio of long-term to short-term debt, in addition to debt-equity ratios. Determinants of capital structure are dependent upon these ratios with the main factors being organizational size, cost of fixed assets, organizational purpose or focus, legal requirements, organizational control, investment requirements, reasons for obtaining finance, terms of finance, market conditions, and flexibility required as well as requirements of investors or others who have a stake in organizational outcomes.

Most organizations will seek a balance in capital structure that effectively addresses organizational needs, while allowing all capital, both debt and equity to work productively. Some researchers refer to this as an “ideal” capital structure. Crucial to achieving this ideal structure of capital is to understand those determinants most specific to the organization. Aligning those determinants with the right mix of debt and equity financing helps ensure consistent cash flow, profitability, and required flexibility in deploying capital resources. Examination of capital structure in both nations around the world, as well as businesses of all types, has concluded the aforementioned determinants of capital structure are central to nearly all organization entities.

Fixed assets are important to analyzing capital structure, because without those assets an organization cannot function, which defines their permanency, rather than alludes to their value, which fluctuates. Size of an organization is also crucial, wherein most cases larger capital resources are required of larger organizations or nations. Overall mission and goals of the organization will also determine both sources of capital and how that capital is sourced. Structure of bureaucracy, management and control also influence how capital is structured to protect overall integrity of the organization and its administration. Each of these determinants of capital structure are most often directly under the control of the organization or firm and even can be adjusted to reflect access to capital.

On the other hand, other determinants of capital structure usually require a more analytical approach to ensure an understanding of their potential impact on the organization. Legal requirements will often determine what types of capital an organization can access, such as parliament of a nation applying a ceiling to the amount of debt a nation can hold. Potential finance arrangements and consideration of tapping into equity are usually assessed to determine their impacts in both the short-term and the long-term. Market conditions and investor or stakeholder requirements also have to be analyzed to assess impact on utilizing various types of investments to meet organizational goals. Each of these determinants of capital structure are taken into consideration on a continual basis, with capital structure being revised when required to align organization goals with required accessible capital resources.

What Is the Connection Between Capital Structure and Firm Value?

The connection between capital structure and firm value comes from the former financing activities that increase the latter. Capital structure is a mix of operating funds, debt financing, and equity financing that pays for new projects or activities that increase revenues and a firm’s economic wealth. For example, starting a new product line may be extremely costly for a business; through the use of external funds and an efficient production process, however, it can be done properly. A company’s capital structure and firm value may be one of the most scrutinized parts of a balance sheet. This is true because those who loan the company money through debt or equity financing want to ensure they will receive adequate financial remuneration for an investment.

A company’s firm value may also carry the name economic value, which is usually the difference between total assets and total liabilities. The result is the true economic value the company generates through business activities. Capital structure and firm value has a connection to physical assets on the balance sheet as these items are usually the result of funds from external sources. In some cases, it is possible that the total liabilities of a firm are higher than the total assets listed on the balance sheet. The end result is a negative total economic value due to inefficient financial processes resulting from business activities.

Two different financial ratios exist for measuring the connection between a company’s capital structure and firm value: return on debt and return on equity. Each formula focuses on a specific type of outside funds that may be in use for payment of large projects or business activities. Each formula has net income or net profit as the numerator; the denominator is either total long-term debt or total equity, depending on the type of external funds in use. The result is a percentage of return, with higher percentages meaning the company is earning more money on the funds and is therefore more efficient. Creating a combination formula for measuring the use of both types of funds on a project is also possible through slight changes in the calculations.

Not all companies have connections between capital structure and firm value. The obvious issue at hand is the lack of capital funding that may exist in a business. No capital structure, therefore, equals zero need for measuring firm value in this manner. Additionally, smaller companies that do not have the ability to issue stock only have debt in their capital structures. This can make the measuring of capital structure and firm value slightly less important than when stockholders have vested interests in a business

Financial Leverage And Capital Structure Policy

Introduction To Financial Leverage And Capital Structure Policy

Capital structure, the mixture of a firm's debt and equity, is important because it costs a company money to borrow. Capital structure also matters because of the different tax implications of debt vs. equity and the impact of corporate taxes on a firm's profitability. Firms must be prudent in their borrowing activities to avoid excessive risk and the possibility of financial distress or even bankruptcy.
A firm's debt-to-equity ratio also impacts the firm's borrowing costs and its value to shareholders. The debt-to-equity ratio is a measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.
If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this financing increases earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. Insufficient returns can lead to bankruptcy and leave shareholders with nothing.
The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies tend to have a debt/equity ratio of under 0.5. (Read more inSpotting Companies In Financial Distress and Debt Ratios: Introduction.) A company can change its capital structure by issuing debt to buy back outstanding equities or by issuing new stock and using the proceeds to repay debt. Issuing new debt increases the debt-to-equity ratio; issuing new equity lowers the debt-to-equity ratio.
As you will recall from Section 13 of this walkthrough, minimizing the weighted average cost of capital(WACC) maximizes the firm's value. This means that the optimal capital structure for a firm is the one that minimizes WACC.
In this section, we'll go into the details of a firm's capital structure, financial leverage, the optimal capital structure and real-world capital structures. We'll also talk about financial distress and bankruptcy, and Modigliani and Miller's ideas about capital structure and firm value when taking corporate taxes into account.

Capital Structure

For stock investors that favor companies with good fundamentals, a strong balance sheet is an important consideration for investing in a company's stock. The strength of a company' balance sheet can be evaluated by three broad categories of investment-quality measurements: working capital adequacy, asset performance and capital structure. In this section, we'll consider the importance of capital structure.
A company's capitalization (not to be confused with market capitalization) describes its composition of permanent or long-term capital, which consists of a combination of debt and equity. A company's reasonable, proportional use of debt and equity to support its assets is a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a corresponding high level of equity is a very positive sign of financial fitness. (Learn about market capitalization in Market Capitalization Defined.)
Clarifying Capital Structure-Related Terminology
The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity consists of a company's common and preferred stock plus retained earnings, which are summed up in the shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety, comprises a company's capitalization and acts as a permanent type of funding to support a company's growth and related assets.
A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities. Investors should understand that there is a difference between operational and debt liabilities - it is the latter that forms the debt component of a company's capitalization. That's not the end of the debt story, however.
Among financial analysts and investment research services, there is no universal agreement as to what constitutes a debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-term debt. However, this definition is too simplistic. Investors should stick to a stricter interpretation of debt where the debt component of a company's capitalization should consist of the following: short-term borrowings (notes payable), the current portion of long-term debt, long-term debt, and two-thirds (rule of thumb) of the principal amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for stock investors.
Capital Ratios and Indicators
In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure. The first two, the debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that delivers the key insights to evaluating a company's capital position.
The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and, therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope, which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also, unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.
The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure (the sum of obligations categorized as debt plus the total shareholders' equity) to the equity component. Expressed as a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high percentage of debt. (To continue reading about ratios, see Debt Reckoning.)
Additional Evaluative Debt-Equity Considerations
Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and other similar long-term, fixed-maturity types of borrowings. No matter how problematic a company's financial condition may be, the holders of these obligations cannot demand immediate and full repayment as long the company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded debt to total debt, the better. Funded debt gives a company more wiggle room.
Factors That Influence a Company's Capital-Structure Decision
The primary factors that influence a company's capital-structure decision are as follows:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure [E1] in both good times and bad.
2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
3. Financial Flexibility
Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times and avoid stretching their capabilities too far. The lower a company's debt level, the more financial flexibility a company has.
Let's take the airline industry as an example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top. (Learn more about this industry in Dead Airlines And What Killed Them and 4 Reasons Why Airlines Are Always Struggling.)
4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company'searnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance growth as their revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant. (Read more about market conditions in The Cost Of Unemployment To The Economy andBetting On The Economy: What Are The Odds?)

 

Financial Leverage

Financial leverage is the degree to which a company uses fixed-income securities such as debt and preferred equity. The more debt financing a company uses, the higher its financial leverage. A high degree of financial leverage means high interest payments, which negatively affect the company's bottom-line earnings per share.
Financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company. (Learn more about leverage in ETFs: Losing At Leverage and 5 Ways Debt Can Make You Money.)
Degree of Financial Leverage
The formula for calculating a company's degree of financial leverage (DFL) measures the percentage change in earnings per share over the percentage change in EBIT. DFL is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt.
Formula:
DFL = percentage change in EPS or EBIT
percentage change in EBIT EBIT-interest
A shortcut to keep in mind with DFL is that if interest is 0, then the DLF will be equal to 1.
Example: Degree of Financial Leverage
With Newco's current production, its sales are $7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are $2.4 million. The company's annual interest expense is $100,000. If we increase Newco's EBIT by 20%, how much will the company's EPS increase?
Calculation and Answer:
The company's DFL is calculated as follows:
DFL = ($7,000,000-$2,800,000-$2,400,000)/($7,000,000-$2,800,000-$2,400,000-$100,000)
DFL = $1,800,000/$1,700,000 = 1.058
Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%. (For further reading, see Will Corporate Debt Drag Your Stock Down?)

 

Modigliani And Miller's Capital Structure Theories

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends.
The basic M&M proposition is based on the following key assumptions:

• No taxes
• No transaction costs
• No bankruptcy costs
• Equivalence in borrowing costs for both companies and investors
• Symmetry of market information, meaning companies and investors have the same information
• No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. To understand how the M&M proposition works after factoring in corporate taxes, however, we must first understand the basics of M&M propositions I and II without taxes.
Modigliani and Miller's Capital-Structure Irrelevance Proposition
The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy costs. In this simplified view, the weighted average cost of capital (WACC) should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes or benefits to the WACC. Additionally, since there are no changes or benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.
However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs.
Modigliani and Miller's Tradeoff Theory of Leverage
The tradeoff theory assumes that there are benefits to leverage within a capital structure up until the optimal capital structure is reached. The theory recognizes the tax benefit from interest payments - that is, because interest paid on debt is tax deductible, issuing bonds effectively reduces a company's tax liability. Paying dividends on equity, however, does not. Thought of another way, the actual rate of interest companies pay on the bonds they issue is less than the nominal rate of interest because of the tax savings. Studies suggest, however, that most companies have less leverage than this theory would suggest is optimal. (Learn more about corporate tax liability in How Big Corporations Avoid Big Tax Bills and Highest Corporate Tax Bills By Sector.)
In comparing the two theories, the main difference between them is the potential benefit from debt in a capital structure, which comes from the tax benefit of the interest payments. Since the MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are recognized.
In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of debt is more valuable because of the interest tax shield.
MM II deals with the WACC. It says that as the proportion of debt in the company's capital structure increases, its return on equity to shareholders increases in a linear fashion. The existence of higher debt levels makes investing in the company more risky, so shareholders demand a higher risk premium on the company's stock. However, because the company's capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes acknowledges the corporate tax savings from the interest tax deduction and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the company's WACC.

 

Bankruptcy Costs And Optimal Capital Structure

Bankruptcy Costs
M&M II might make it sound as if it is always a good thing when a company increases its proportion of debt relative to equity, but that's not the case. Additional debt is good only up to a certain point because of bankruptcy costs.
Bankruptcy costs can significantly affect a company's cost of capital. When a company invests in debt, the company is required to service that debt by making required interest payments. Interest payments alter a company's earnings as well as cash flow.
For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender.
The risk of bankruptcy increases with the increased debt load. Since the cost of debt becomes higher, the WACC is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly. (Read more about bankruptcy in Not Too Big To Fail: Corporate Financial Struggles and An Overview Of Corporate Bankruptcy.)
Optimal Capital Structure
Is there an optimal debt-equity relationship? In financial terms, debt is a good example of the proverbial two-edged sword. Astute use of leverage (debt) increases the amount of financial resources available to a company for growth and expansion. The assumption is that management can earn more on borrowed funds than it pays in interest expenses and fees on these funds. However, as successful as this formula may seem, it does require that a company maintain a solid record of complying with its various borrowing commitments. (For more stories on company debt loads, see Will Corporate Debt Drag Your Stock Down? and Burn Rate Key Factor In Company's Sustainability.)
A company considered too highly leveraged (too much debt versus equity) may find its freedom of action restricted by its creditors and/or may have its profitability hurt as a result of paying high interest costs. Of course, the worst-case scenario would be having trouble meeting operating and debt liabilities during periods of adverse economic conditions. Lastly, a company in a highly competitive business, if hobbled by high debt, may find its competitors taking advantage of its problems to grab more market share.
Unfortunately, there is no magic proportion of debt that a company can take on. The debt-equity relationship varies according to industries involved, a company's line of business and its stage of development. However, because investors are better off putting their money into companies with strong balance sheets, common sense tells us that these companies should have, generally speaking, lower debt and higher equity levels. (Read about personal debt in What's Your Debt Really Costing You? and Debt Settlement Arrangements And Your Credit Score.)
What Is the Optimal Capital Structure?
As we have seen, some debt is often better than no debt, but too much debt increases bankruptcy risk. In technical terms, additional debt lowers the weighted average cost of capital. Of course, at some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind that the following are general principles:
First, optimal capital structure varies by industry, mainly because some industries are more asset-intensive than others. In very general terms, the greater the investment in fixed assets (plant, property and equipment), the greater the average use of debt. This is because banks prefer to make loans against fixed assets rather than intangibles. Industries that require a great deal of plant investment, such as telecommunications, generally use more long-term debt.
Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups and early stage companies, for instance, often favor equity over debt because their shareholders will forgo dividend payments in favor of future price returns. These companies are considered growth stocks. High-growth companies do not need to give these shareholders cash today; however lenders would expect semi-annual or quarterly interest payments.
In summary, the optimal capital structure is the mix of debt, preferred stock and common equity that will optimize the company's stock price. As a company raises new capital it will focus on maintaining this optimal capital structure.

 

 

Extended Pie Model, Observed Capital Structures And Long-Term Financing

Extended Pie Model
The extended pie model draws upon Modigliani and Miller's capital structure irrelevance theory. This model considers both corporate taxes and bankruptcy costs to be a claim on the firm's cash flows and illustrates the proportion of each entity's claim on the company's cash flows using pie charts. These pie charts also show how an increase or decrease in the company's debt relative to its equity increases or decreases each entity's claim. Under the extended pie model, stockholders, bondholders, the government, bankruptcy courts, lawyers and other entities are each considered to have a partial claim on the company's cash flows. The size of each slice of the pie represents each entity's percentage claim.
The extended pie model helps illustrate the relationship between the value of the firm and its cash flows. It is an extension of Modigliani and Miller's theory because it attempts to show a way in which capital structure does not affect the firm's value.
Observed Capital Structures
Observed capital structure refers to the real-life capital structures of various industries as a whole as well as the individual businesses within those industries. Different industries have different proportions of debt and equity because they require varying levels of investment in plant, property and equipment. For example, capital-intensive industries tend to have more debt because banks are willing to make loans against fixed assets. Within the same industry, firms may have similar capital structures because similar businesses may have similar assets and liabilities. However, within the same industry, a given business's capital structure may differ from industry norms because of factors such as firm size, technology requirements and growth stage. (Learn more about the differences among major industries in our Industry Handbook.)
The Ibbotson Cost of Capital Yearbook, which as of February 2012 is published annually and updated quarterly, is a comprehensive and authoritative source of business valuation statistics, including cost of equity, cost of debt and weighted average cost of capital. According to the 2008 yearbook, the industries with the lowest debt levels were computers (5.61%) and drugs (7.25%). The industries with the highest debt levels were cable television (162.03%) and airlines (129.04%).
These numbers can change significantly in even a short amount of time. The same survey in 2004 also found that the industries with the lowest debt levels were drugs (6.38%) and paper and computers(10.24% to 10.68%), but the industries with the highest debt levels were airlines (64.22%) and electric utilities (49.03%). Notice the dramatic increase in the debt levels of the high-debt industries from 2004 to 2008.
Large capital outlays are also a fact of life for most telecom industry players. To finance their CAPEXinitiatives, they often rely on debt financing. Department stores and steel companies have also historically had relatively high levels of debt. On the whole, however, U.S. corporations generally prefer equity financing over debt financing and therefore have low debt-to-equity ratios.
Long-Term Financing under Financial Distress/Bankruptcy
Financial distress is a condition in which a company cannot meet or has difficulty paying off its financial obligations to its creditors. The chance of financial distress increases when a firm has highfixed costs, illiquid assets or revenues that are sensitive to economic downturns.
A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise much-needed funds. In an effort to satisfy short-term obligations, management might forego profitable longer-term projects. Employees of a distressed firm usually have higher stress, lower morale and lower productivity caused by the increased chance of the company's bankruptcy, which would force them out of their jobs.
Bankruptcy is a legal proceeding involving a person or business that is unable to repay outstanding debts. The bankruptcy process begins with a petition filed by the debtor (most common) or on behalf of creditors (less common). All of the debtor's assets are measured and evaluated, whereupon the assets are used to repay a portion of outstanding debt. Upon the successful completion of bankruptcy proceedings, the debtor is relieved of the debt obligations incurred prior to filing for bankruptcy.
Bankruptcy offers an individual or business a chance to start fresh by forgiving debts that simply can't be repaid while offering creditors a chance to obtain some measure of repayment based on what assets are available.
Bankruptcy filings in the United States can fall under one of several chapters of the Bankruptcy Code, such as Chapter 7 (which involves liquidation of assets), Chapter 11 (company or individual "reorganizations") and Chapter 13 (debt repayment with lowered debt covenants or payment plans). Bankruptcy filing specifications vary widely among different countries, leading to higher and lower filing rates depending on how easily a person or company can complete the process.
Some firms are at greater risk of financial distress than others. Any firm with volatile earnings has an increased risk of financial distress. For example, a retail company might be considered at greater risk of financial distress because many retail companies have dramatically higher sales in the fourth quarter than in other quarters. Firms whose value largely derives from intangible assets are also at higher risk of financial distress since they have little that can be sold off to repay debt. (For related reading, see Well-Established Brands Worth Billions and June Retail Sales: Worthless Data Or Valuable Tool?)
Firms with a higher risk of financial distress are well advised to issue bonds with caution since they may struggle to repay the debt. Financial distress does not just harm bondholders and stockholders who stand to lose their investments; it also harms the firm in ways that make a bad situation worse. As we mentioned above, a firm in financial distress will find it more difficult and more expensive to borrow. Difficulty in borrowing or in obtaining credit from suppliers can diminish inventory and make it harder to make sales and to retain and attract customers. Existing and potential customers may seek alternatives with companies that have better inventories and that they are confident they can return to for repeat business. Financial distress can also cause the firm to lose key talent to more stable job opportunities. Finally, filing for bankruptcy requires expensive legal assistance.
The costs of financial distress and bankruptcy thus illustrate once again why choosing an optimal capital structure and not taking on too much long-term debt are crucial to a firm's vitality and longevity. (Read more in The 5 Best Corporate Comebacks and Cash In On Companies With Declining Sales.)

Why Capital Structure Matters

By MICHAEL MILKEN

Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, "I'll never own a stock again!" Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.

Chad Crowe

If that all sounds familiar today, it's worth remembering that 1974 was also a turning point. With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That's 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles.

This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity. These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.

The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company's securities or the risk of investing in them.

My belief -- first stated 40 years ago in a graduate thesis and later confirmed by experience -- is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors -- the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it's happening again.

Overleveraging in many industries -- especially airlines, aerospace and technology -- started in the late 1960s. As the perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply. But by using the capital markets to deleverage -- by paying off these securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt -- most companies avoided default and saved jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which it was retired.)

Issuing new equity can of course depress a stock's value in two ways: It increases the supply, thus lowering the price; and it "signals" that management thinks the stock price is high relative to its true value. Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

The decision to increase or decrease leverage depends on market conditions and investors' receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late '80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.

In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years. As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance sheets. That has helped save jobs.

The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market's recent fall. These purchases peaked at more than $700 billion in 2007 near the market top -- and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world's largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy's, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality. The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of the time.

History isn't a sine wave of endlessly repeated patterns. It's more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

It doesn't matter whether a company is big or small. Capital structure matters. It always has and always will.

Mr. Milken is chairman of the Milken Institute.