Capital Structure and
Operational Strategy
P.V. Viswanath
Financial Theory
and
Strategic Decision-Making
Outline
Capital Structure and Consumers
Capital Structure, Financial Distress and Consumer
Confidence
Financial Distress and Reputation
Capital Structure and the Supply Chain
Capital Structure and Suppliers
Capital Structure and Employment Decisions
Capital Structure and Employees
Credible Commitment
Capital Structure and Hiring Discipline
Leverage & Collective Bargaining
Capital Structure and Employment Decisions
Leverage & Bargaining with the Government
Outline
Debt Overhang and Negotiating with Creditors
Commitment and Strategy
Commitment vs. Involvement
Credible Commitment
Commitment with Financing Policy
Capital Structure and Competitive Strategy
Debt and Aggression
Debt Overhang and Commitment
Discount Rates and Agression
Debt and Predation
Debt and Agression
Cash and Agression
Excess Debt & Customer Confidence
Capital Structure and Location
Capital Structure, Liquidation and
Consumer Confidence
We have seen that a leveraged firm is less likely to
liquidate.
However once a firm goes bankrupt, lenders get some
say in firm decisions through the bankruptcy process, and
lenders prefer liquidation because they get paid first from
liquidation.
Liquidation affects customers of firms that make durable
products.
Since a liquidated firm will no longer produce, customers
are unlikely to get replacement parts.
Warranties are also less likely to be honored.
As a result, customers are less likely to buy durable
products from firms that are likely to be liquidated.
This suggests that a firm’s capital structure could affect
the efficacy of marketing strategies. Alternatively, lack of
leverage could be used in a firm’s advertising.
Capital Structure, Bankruptcy and
Consumer Confidence
Are Consumers Affected by Durable Goods Makers’ Financial
Distress? The Case of Auto Manufacturers by Hortacsu et al.
We find that an increase in an auto manufacturer’s
financial distress (as measured by an increase in its CDS
spread) does result in a contemporaneous drop in the
prices of its cars at auction, controlling for a host of other
influences on price.
Furthermore, cars with longer expected service lives (those
within manufacturer warranty, having lower mileage, or in
better condition) see larger price declines than those with
shorter remaining lives.
These patterns do not seem to be driven solely by reduced
demand from auto dealers affiliated with the troubled
manufacturers or by contemporaneous declines in new car
prices.
http://home.uchicago.edu/syverson/financeanddurables.pdf
Financial Distress and Reputation
We have seen that the likelihood of financial distress
can provide an incentive for firms to become shortsighted and to take risky, and NPV<0 projects.
Non-financial stakeholders are therefore likely to be
concerned that a distressed firm will become capital
constrained, which could then cause managers to
make short-sighted cutbacks in value-increasing
investments.
Critical among such investments are the money and
effort spent in maintaining the firm’s reputation for
dealing honestly with employees and suppliers, and
for providing quality products to its customers.
http://www2.mccombs.utexas.edu/faculty/andres.almazan/Article6.pdf
Financial Distress and Reputation
Under normal circumstances, managers have strong
incentives to maintain their firms’ reputation
because that contributes to higher long run
profitability.
Under financial duress, however, the long-run value
of a good reputation may be less important than
the immediate need to generate cash to stave off
bankruptcy. For this reason, a firm may lower the
quality of its products in order to raise cash to meet
debt obligations.
As we have already seen, the existence of debt
could cause a firm to pick short-term oriented
projects.
Excess Debt & Customer Confidence
Once we note the impact of leverage on customer
confidence, it’s easy to see that a potential solution to the
problem is recapitalization.
The problem is that it is precisely in this situation that
funds are difficult to come by.
Furthermore, recapitalization can have the effect of
transferring value to debt-holders.
However, if the problems of the firm are purely financial
and the business model is good, it may be possible to
attract PIPE (Private Investment in Public Equity) if the
firm is publicly held, or private equity if the firm is
privately held. Information asymmetry would affect PIPE
investment less than issuance of public equity.
If the effect on customer confidence is high, it could
trump the loss in shareholder value due to wealth transfer
to bondholders.
Capital Structure and Suppliers
“Retailers rely heavily upon their suppliers for financing. These suppliers,
in turn, regulate their own risk exposures through their selection of
customers, and tend to respond rapidly to changes in customer
creditworthiness.”
“Just so with Hechinger Co., a U.S.-based retailer of do-it-yourself home
products. In 1999, Hechinger defaulted on an interest payment. Anxious
suppliers cut back on credit, intensifying Hechinger’s cash crunch. During
the critical warm months when do-it-yourself sales typically peaked,
potential Hechinger customers were greeted by nearly empty stores,
leading to rapid deterioration of the firm’s condition as customers left to
shop elsewhere. Hechinger was soon forced to liquidate its operations.”
Clearly, suppliers may be unwilling to provide a firm with inventory if
they think they might not be paid. Here’s another example:
(Corporate Finance, London: Feb 2002, issue 207, p. 8) Many Kmart
shoppers have suffered the embarrassment of being strapped for cash at
the checkout, but this time the shoe is on the other foot. Discount
retailer Kmart did not have enough money to pay Fleming Companies, its
food supplier, and filed for bankruptcy in January.
Fleming is owed $77 million, and joined the tough suppliers who
suspended shipments to the struggling retailer - the final blow for Kmart,
who promotes itself as the home of low prices.
Integrated Risk Management for the Firm: A Senior Manager’s Guide, Lisa K. Meulbroek, 2002
Capital Structure and Suppliers
Kimberley Blanton’s article in The Boston Globe on Thursday
December 4, 1997 (City Edition) cites: “… the Chapter 11 filing
in US Bankruptcy Court in Boston by Waltham-based Molten
Metal was triggered when suppliers refused to extend
additional credit to the company, which had already slowed
payment of its bills.”
Molina and Preve also find that retailers are forced to reduce
their dependence on trade credit in times of financial distress.
Clearly financial distress can impact on a firm’s relations with
suppliers.
It is obvious that financial distress has a lot to do with a firm’s
choice of financial leverage. The greater the debt in the firm’s
capital structure, the greater the likelihood of financial
distress.
Suppliers are likely to look at these factors in deciding on the
terms to grant their customers. A savvy firm can use its
financial stability to bargain for better credit terms.
An Empirical Analysis of the Effect of Financial Distress on Trade Credit, Molina and Preve, 2007
Capital Structure and Employees
A highly leveraged firm is more likely to go bankrupt and
a bankrupt firm is more likely to be liquidated.
Highly levered firms have a greater tendency to lay off
workers and reduce employment in response to a shortterm reduction in demand.
A firm with less onerous debt obligations may be willing
to maintain high employment when times are bad, in
order to reduce the future costs of hiring and retraining
workers when demand increases. That is, this is the firstbest optimum.
However, a more highly levered firm may be forced to cut
costs by laying off workers to meet its debt obligations.
It cannot raise funds even to fund carrying unnecessary
workers short-term because levered firms have perverse
incentives, as we have seen. Levered firms that are close
to financial distress are likely to be myopic in their
investments.
Capital Structure and HR
A disbelieving financial analyst might
make a comment such as the following
statement:
A firm in financial distress will lay off
workers because it doesn’t have
sufficient funds. This has nothing to do
with capital structure.
Can you convince her otherwise?
Capital Structure and Hiring
Discipline
For the last two decades, firms with higher debt
have reduced their employment more often, used
more part time and seasonal employees, paid lower
wages, and funded pension plans less generously.
These effects are economically significant and
cannot be explained by variation in performance.
Debt seems to discipline the employment
relationship.
The apparent employment effects of debt are not
substantially affected by controls for growth
opportunities. The relation between debt and
employment reductions is significant only at high
debt levels, suggesting that only high debt levels
can force employment reductions.
Debt and the terms of employment, Gordon Hanka, JFE 1998
Leverage & Collective Bargaining
Can capital structure have an impact on a
firm’s collective bargaining?
Here’s a statement from an Eastern Airlines
union leader:
More debt for Eastern meant greater
pressure to cut costs. . . . [The company] is
embarked on a confrontation between labor
and interest costs. It’s not labor and
management. It’s labor and interest cost.
Farrell Kupersmith, Pilots’ Union Representative
So it seems some people think so. But what
is the nature of this connection?
Leverage & Collective Bargaining
David Matsa analyzed the strategic use of debt financing to
improve a firm’s bargaining position with organized labor.
Because maintaining high levels of corporate liquidity can
encourage workers to raise their wage demands, a firm with
external finance constraints has an incentive to use the cash flow
demands of debt service to improve its bargaining position with
workers.
Using both firm-level collective bargaining coverage and state
changes in labor laws to identify changes in union bargaining
power, Matsa showed that strategic incentives from union
bargaining appear to have a substantial impact on corporate
financing decisions.
In other words, firms with excess cash cannot credibly threaten
labor demands with dire consequences. Hence it might make
sense for a firm to have large amounts of debt that might enable
it to force labor to make concessions at difficult times. Thus, in
good times, leverage increases ROE, while, in bad times, it can
reduce labor costs.
Capital Structure as a Strategic Variable: Evidence from Collective
Bargaining, David Matsa, JF 2010
Leverage & Collective Bargaining
Here’s an example from the airline industry:
Airlines in financial distress obtain wage concessions from
employees whose pension plans are underfunded in that plan
assets are insufficient to cover outstanding liabilities. Since
employees with underfunded pension plans bear a higher cost
when firms default, their outside option in the event of default is
reduced. Therefore, in bargaining, management can employ the
threat of ‘pension dumping’ to extract greater concessions from
labor.
Pensions are partially insured by the PBGC. Since highly-paid
employees with promised pensions that exceed the PBGC
guarantee stand to lose more when their pension is dumped,
they are more likely to make concessions during labor
bargaining.
In renegotiation financially constrained airlines with underfunded
pension plans extract between $12,252 and $17,360 in annual
wages from employees not fully covered by the PBGC
guarantee.
Negotiating with Labor under Financial Distress, Benmelech et al.
Financial Leverage and Leverage Over Labor
Jayant Kale, Harley Ryan and Lingling Wang in a
paper entitled “Outside Employment Opportunities,
Employee Productivity, and Debt Disciplining” show
that debt in the capital structure increases the
productivity of the firm’s employees.
They also find that this positive productivityleverage relation becomes stronger when outside
employment opportunities for employees worsen.
They look at the effects of the implementation of
NAFTA, an exogenous shock to employment
opportunities in certain industries; on average, it
strengthened the positive productivity-leverage
relation for firms in these industries.
This suggests that debt increases labor productivity
by means of the increased leverage that the firm
has on its employees.
Leverage & Bargaining with the Govt.
Too large to fail? Can a firm be too important to a
local government to fail?
If there are positive externalities to the operations of a
firm, in terms of employment of the local population
with the attendant positive effects of lower crime etc.,
governments might be willing to provide guaranteed
loans to such firms in the event of financial distress
Thus, the US government guaranteed loans to Chrysler
and received warrants in return.
The Canadian government provided guarantees to
Massey-Ferguson on a preferred stock issue in return
for a promise not to lay off workers in Canada.
Thus capital structure and financing policy can be a
means for a firm to extract the value of positive
externalities.
Debt Overhang and
Negotiating with Creditors
Similarly, excessive debt leading to debt overhang and inhibited
investment can lead to a stronger negotiating position vis-à-vis
bondholders.
The debt-overhang problem may be so severe that creditors can
actually benefit from forgiving a portion of the debt.
With excessively high levels of debt, the risk of default is large
and the market value of debt is well below its face value. If the
creditors forgive part of the debt in this situation, the lower debt
burden helps realign the interests of the equity holders and the
creditors.
The firm’s effort and investment will rise, increasing the total
value of the firm and the market value of the remaining debt. If
this effect is strong enough, the market value of the remaining
debt may be even higher than the market value of the total debt
in the absence of debt forgiveness, in which case debt relief will
ultimately benefit the creditors themselves.
http://www.clevelandfed.org/research/commentary/2010/2010-7.cfm
Capital Structure and Location
There is evidence that firms in the same
location exhibit similar capital structures.
Apparently, local culture and social interactions
among corporate executives, play a significant
role in influencing corporate financial policies of
firms headquartered in the same metropolitan
area.
What does this imply for the location decision?
Does Corporate Headquarters Location Matter for Firm Capital Structure? By
Wenlian Gao, Lilian K. Ng and Qinghai Wang, SSRN 2010
Capital Structure and Location
There is also evidence that firms that are located in rural
areas or in areas that are distant from financial centers are
more subject to information asymmetry than nearby firms.
The reason is that there are fewer equity analysts in these
locations. As a result, it is more difficult for such firms to
obtain outside equity.
Loughran and Schultz (2006) find that that rural firms wait
longer to go public, are less likely to conduct seasoned
equity offerings, and have more debt in their capital
structure than otherwise similar urban firms.
This suggests that if entrepreneurs believe that they are
more likely to have difficulties in obtaining financing,
perhaps because they don’t have networking capabilities,
then they should locate in urban areas close to financial
centers.
“Asymmetric Information, Firm Location, and Equity Issuance” by
Loughran and Schultz, JFQA 2006