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Capital Structure

Course Module in Introductory Finance

Course Modules help faculty select and sequence HBS Publishing titles for use in segments of a course.
Each module represents subject matter experts’ thinking about the best materials to assign and how to
organize them to facilitate learning. In making selections, we’ve received guidance from faculty at Harvard
Business School and other major academic institutions.

Each module recommends four to six items. Whenever possible at least one alternative item for each
main recommendation is included. Cases form the core of many modules, but we also include readings
from Harvard Business Review, HBS background notes, and other course materials.

I. Overview of suggested content (HBS cases except as noted)

Title Author Product Publication Pages Teaching


Number Year Note
Introduction
1. Note on the Theory of Optimal Fruhan 279069 1979 7p 292047
Capital Structure (Note)
Tax Benefits of Debt
2. Debt Policy at UST, Inc Mitchell 200069 2000 14p 201002
Supplement: Is a Share Buyback Pettit R0104K 2001 7p --
Right for Your Company? (HBR)
Alternative: American Home Mullins 283065 1983 (Rev. 7p 292060
Products Corp. 1989)
Costs of Financial Distress
3. The Loewen Group, Inc. Tufano 201082 2001 13p 204138
(Abridged)
Alternative: UAL, 2004: Pulling Bergstresser 205090 2005 24p (to come)
Out of Bankruptcy
Alternative: Massey-Ferguson Baldwin 282043 1982 (Rev. 16p 292064
Ltd.—1980 1990)
Integrating Capital Structure
Decisions
4. Seagate Technology Buyout Andrade 201063 2001 19p 204160
Supplement: How Much Cash Passov R0311J 2003 9p --
Does Your Company Need?
(HBR)
Alternative: MCI Communications Greenwald 284057 1984 (Rev. 14p 386110
Corp.--1983 1998) 292077

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Capital Structure: An HBSP Course Module

Dividend Policy
5. Dividend Policy at Linear Baker 204066 2003 18p 204084
Technology
Alternative: Sealed Air Corp.'s Wruck 294122 1994 (Rev. 21p 295143
Leveraged Recapitalization (A) 1997)

II. Rationale for selection and sequencing the items in this module
The module starts out with a technical note, Note on the Theory of Optimal Capital Structure, which
clearly introduces the standard theory behind finding a capital structure that simultaneously maximizes a
firm’s market value while minimizing its weighted average cost of capital (WACC). The note contains step-
by-step numerical calculations and visual graphics that let the class work through the changing
relationships as debt is increased in a theoretical company’s capital structure from 0% to 50%.

Both cases in segment 2 require students to quantify the benefit to shareholders from the interest tax
shield of debt. Debt Policy at UST focuses on a company undergoing a major recapitalization. The
supplementary HBR article “Is a Share Buyback Right for Your Company?” further explores optimal
capital structure issues for companies following UST’s example of a debt-financed share repurchase
program. When managed right (the company must have predictable, taxable profits to shield), debt
financing can increase a company’s value significantly, including the cash flow discipline it imposes on
managers. For a more philosophical discussion, instructors may want to consider the classic American
Home Products case, which challenges students to defend the textbook advantages of debt in light of a
conservative, financially successful company with no debt in its financial structure.

The third segment turns to the likelihood and costs of bankruptcy with high levels of debt that must be
weighed against its tax advantages when determining optimal capital structure. The main suggestion,
Loewen Group, describes a funeral home consolidator’s “unsustainable” growth through debt-financed
acquisition. Students must analyze why it faces financial distress when the industry hits difficult times.
The first alternative case— UAL, 2004: Pulling Out of Bankruptcy—focuses on how a bankrupt United
Airlines can reorganize despite an unexpected loan rejection and heavy pension obligations. It highlights
the interesting impact on leverage of unionized labor. Massey Ferguson, the second, time-tested
alternative offers a complex restructuring, involving government negotiations, of a multinational farm
equipment manufacturer.

The fourth section of the module places the issues raised in the previous sections in a more complex,
dynamic setting. The first selection, Seagate Technology, concerns a complicated capital structure
situation—a leveraged buyout (LBO) in a capital-intensive industry. Because leveraged buyouts increase
the risk of financial distress, this is a rich case that lets instructors explore cash flow valuation of
leveraged firms (using adjusted present value and WACC techniques) and stock market efficiency.

The supplementary Harvard Business Review article, “How Much Cash Does Your Company Need?”
proposes an adjustment to the traditional capital structure model to account for the complication faced by
companies in knowledge-intensive industries such as pharmaceuticals and software. In order to reinvest

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in highly volatile intangible assets (research projects) and thus reduce the costs of financial distress, such
companies maintain lower rates of leverage and higher cash balances than theory would predict.

The alternative bestseller on MCI Communications Corp. is a comprehensive financing case that requires
MCI to estimate its external financing needs in light of the uncertain competitive impact on the
telecommunications industry of the AT&T antitrust settlement. With a large need for funds and a risky
future ahead, MCI considers a full range of financial instruments, including “junk” bonds and convertibles,
before determining a target debt policy and which security to issue.

In the final segment, the Linear Technology case involves a traditional dividend-cutting decision for a
semiconductor firm whose payout ratio is considered high for the industry, at a time when tax legislation
and stock market valuations favor dividend-paying companies. The case discussion brings up the
Modigliani and Miller theorem—in perfect capital markets, dividend policy is irrelevant to firm value. In the
multidisciplinary alternative case, Sealed Air borrows substantially to pay a one-time special cash
dividend to its shareholders. With this decision, the company aims not only to reach the value-
maximizing benefits of leverage, but also to use the key event to change the organization’s manufacturing
culture. The case can be taught at both introductory and advanced levels in a finance course.

III. Detailed description of recommended items


Introduction
1. Note on the Theory of Optimal Capital Structure William E. Fruhan Jr.
Examines the interrelationship between the maximization of the share value of a firm's common stock and
the minimization of the firm's weighted average cost of capital. Presents a revised version of a case by
J.W. Mullins, Jr.
Subjects Covered: Capital costs; Capital structure; Corporate strategy; Financial management; Goal
setting Length: 7p

• Discusses impact of leverage on firm’s income statement, required return on capital, firm’s
market value, book value, earnings per share, and weighted average cost of capital (WACC).
• In this basic model, the optimal debt level maximizes the firm’s value/share price and minimizes
WACC. At excessive levels of leverage, the present value of the costs of likely financial distress
outweigh the present value of the tax benefits of debt, thus driving up the cost of capital and
decreasing firm value.
• Once students have understood the mechanics and assumptions in the note’s model, the
instructor can expand into discussing how differing business risk between firms in different
industries would affect their optimal debt ratio.

Tax Benefits of Debt


2. Debt Policy at UST, Inc. Mark Mitchell
UST, Inc. is a very profitable smokeless tobacco firm with low debt compared to other firms in the tobacco
industry. The setting for the case is UST's recent decision to substantially alter its debt policy by
borrowing $1 billion to finance its stock repurchase program.

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Learning Objective: To introduce to optimal capital structure, with emphasis on calculation of interest tax
shields.
Subjects Covered: Capital structure; Debt management; Long term financing; Taxation; Tobacco industry
Setting: Greenwich, CT; Tobacco industry; $1.4 billion revenues; 4,765 employees; 1999
Length:14p

• Bestseller
• Students evaluate UST’s business risk from a bondholders’ perspective.
• To assess whether UST should borrow to finance the stock repurchase program, the class
analyzes UST’s ability to make interest payments and then the valuation impact of the
recapitalization.
• Illustrates the relationship between interest coverage and debt ratings.

Supplement: Is a Share Buyback Right for Your Company? Justin Pettit (Harvard Business Review
Article)
Contrary to popular wisdom, buybacks don't create value by raising earnings per share. But they do
indeed create value, and in two very different ways. First, a buyback sends signals about the company's
prospects to the market--hopefully, that prospects are so good that the best investment managers can
make right now is in their own company. But investors won't see it that way if other, negative, signals are
coming from the company, and it's rarely a good idea for companies in high-growth industries, where
investors expect that money to be spent pursuing new opportunities. Second, when financed as a debt
issue, a buyback is essentially an exchange of equity for debt, conferring the traditional benefits of
leverage--a tax shield and a discipline for managers. For such a buyback to make sense, a company
would need to have taxable profits in need of shielding, of course, and be able to predict its future cash
flows fairly accurately. Justin Pettit has found that managers routinely underestimate how many shares
they need to buy to send a credible signal to the markets, and he offers a way to calculate that number.
He also goes through the iterative steps involved in working out how many shares must be purchased to
reach a target level of debt. Then he takes a look at the advantages and disadvantages of the three most
common ways that companies make the actual purchases--open-market purchases, fixed-price tender
offers, and auction-based tender offers. When a company's performance is lagging, a share buyback can
look attractive. Unfortunately, a buyback can backfire--unless executives understand why, when, and how
to use this powerful and risky tool.
Subjects Covered: Capital markets; Capital structure; Dividends; Equity financing; Financial strategy;
Stocks Length: 7p

• Article also mentions share buybacks as an alternative to dividends, which create a larger tax
liability for (U.S.) shareholders.

Alternative: American Home Products Corp. David W. Mullins Jr.


American Home Products is a company with virtually no debt. Students are asked to analyze the
company's debt policy and make a recommendation to the CEO. It is likely that adding debt to the capital
structure would create some value for shareholders; the CEO is firmly against borrowing.
Subjects Covered: Capital structure; Debt management; Financial strategy

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Setting:New York, NY; Pharmaceutical industry; $4.1 billion sales; 1981 Length: 7p

• Bestseller
• Accessible introduction to the complicated issues involved in choosing a debt policy.

Costs of Financial Distress


3. The Loewen Group, Inc. (Abridged) Peter Tufano
A publicly traded funeral home and cemetery consolidator faces imminent financial distress. The
company has grown aggressively through the use of debt. Restructuring the debt is potentially very costly
to creditors, shareholders, suppliers, and other corporate stakeholders. Cross-border and accounting
issues could complicate the restructuring.Learning Objective: To illustrate the costs of debt, financial
distress, basic restructuring options, and determinants of capital structure.
Subjects Covered: Accounting policies; Bankruptcy; Canada; Crisis management; Debt management;
Financial analysis; Financial management; Financial strategy; Reorganization; Services
Setting: British Columbia; Canada; Funeral; $1.1 billion revenues; 16,000 employees; 1998-1999 Length:
13p

• Enables the instructor to introduce the concept of sustainable growth and its limitations in firms
that raise additional equity.
• Discussion differentiates between sources of economic vs. financial distress.
• Students can generalize for which types of firms financial distress is most costly.
• Teaching note contains a supplementary teaching plan for the buyout offer.

Alternative: UAL, 2004: Pulling Out of Bankruptcy Daniel B. Bergstresser, Kenneth A. Froot, Darren R.
Smart
UAL is a large air transportation company with roots that go back to the 1920s. As a legacy carrier, going
back to before the 1978 deregulation of air transportation markets, United Airlines is burdened with cost
structures that make it difficult to compete with newer competitors. In addition, UAL has the burden of
$7.6 billion in unfunded pension obligations and $2 billion in unfunded retiree health obligations. In June
2004, UAL is still operating under Chapter 11 bankruptcy protection, which began December 2002. It has
needed extensions of the exclusivity period from the bankruptcy court. UAL's plan of reorganization is
predicated on receiving $1.8 billion in loan guarantees from the Air Transport Stabilization Board (ATSB).
But its request for loan guarantees from the ATSB was recently rejected. The company must decide what
to do next and how to emerge from bankruptcy. Learning Objective: To examine the costs of financial
distress and to explore the interaction of agency problems and leverage.
Subjects Covered: Airlines, Bankruptcy, Compensation, Costs, Loans, Reorganization. Setting: United
States; Airline industry; $14 billion revenues; 63,000 employees; 2002-2004. Length: 24p

• Compelling study of an industry with frequent bankruptcies since deregulation.


• Illustrates both benefits and strategic and financial costs of bankruptcy status.
• Decision point involves negotiation with labor union regarding pension obligations at time UAL is
trying to launch a low-fare airline.

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• Rich case exhibits graphically depict evolution of cost components and capital structures in the
airline industry.
• Case can be used in a course on corporate finance, restructuring, or financial institutions.

Alternative: Massey-Ferguson Ltd.—1980 Carliss Y. Baldwin; Scott P. Mason; Jennifer H. Hughes


Massey Ferguson began fiscal year 1981 in default on $2.5 billion of outstanding debt. The company's
future depends on the ability of lenders, the governments of Canada and Ontario, and management, to
agree on a refinancing plan. The case reviews Massey's performance and position in the industry and
raises questions about the company's ability to compete in the long run. Provides information on the firm's
claimants in order to focus students on the issues of a refinancing.
Subjects Covered: Bankruptcy; Financial planning; Financial strategy; Machinery; Recapitalization; Short
term financing. Setting: Canada; Agriculture industry; $3 billion sales; 1980-1981. Length:16p

• Bestseller.
• Example of how risky, leverage-intensive financial policy compounds risky product-market
strategy (building infrastructure in less developed countries).
• While Massey-Ferguson is in distress, a competitor with a lower debt ratio is able to obtain
financing at better terms in order to boost its sales and capital expenditures.
• Case contains data on the claims and perspectives of the various lenders in Massey’s
restructuring.

Integrating Capital Structure Decisions


4. Seagate Technology Buyout Gregor Andrade; Todd Pulvino; Stuart C. Gilson
In March 2000, a group of private investors and senior managers were negotiating a deal to acquire the
disk drive operations of Seagate Technology. The motivating factor for the buyout was the apparently
anomalous market value of Seagate's equity: Seagate's equity value was just a fraction of the value of its
minority stake in Veritas Software Corp., a software maker. The investor group had to decide how much
to offer for the operating assets, as well as how to finance the transaction. Further complicating the
analysis was the fact that, unlike in traditional buyout settings, the target company was in a highly cyclical,
volatile, and capital--intensive industry.
Learning Objective: To illustrate cash flow valuation (adjusted present value and WACC), including
estimating the cost of capital from comparables, as well as the impact of financing decisions on value; to
discuss leveraged buyouts, both in traditional settings within mature industries, as well as in the more
volatile technology sector; to discuss tax implications associated with corporate divestitures; and to
qualitatively evaluate potential costs of financial distress in a capital-intensive technology-driven setting.
Subjects Covered: Capital structure; Financial strategy; Leveraged buyouts; Mergers & acquisitions;
Present value; Silicon Valley; Software; Valuation. Setting: Silicon Valley; Computer hardware; $6.8 billion
revenues; 2000. Length: 19p

• Case designed for two-day discussion. First day focuses on pluses and minuses of leveraged
buyouts, whether the proposed LBO is a good option for Seagate, and Seagate’s optimal capital
structure.

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• Second-day’s teaching plan concentrates on the mechanics of valuing Seagate’s assets in order
to assess the fairness of the buyout group’s proposed bid.
• Case illustrates a new trend of the 1990s towards LBOs of potentially undervalued high
technology businesses.
• The proposed LBO for Seagate must be assessed against the industry’s short-term, research-
intensive economics, which magnify the costs of financial distress.

Supplement: How Much Cash Does Your Company Need? Richard Passov (Harvard Business Review)
In late 2001, the directors of Pfizer asked that very question. And with good reason. After its 2000 merger
with rival Warner-Lambert, the New York-based pharmaceutical giant found itself sitting on a net cash
position of $6 billion, which seemed extraordinarily conservative for a company whose products
generated $30 billion in revenues. Most large companies with revenues that healthy would increase
leverage, thereby unlocking tremendous value for shareholders. But knowledge-intensive companies like
Pfizer, this author argues, are in a class apart. Because their largely intangible assets (like R&D) are
highly volatile and cannot easily be valued, they are more vulnerable to financial distress than are firms
with a preponderance of tangible assets. To insure against that risk, they need to maintain large positive
cash balances. Only by investing in their intangible assets can knowledge-based companies hope to
preserve the value of those assets.
Subjects Covered: Balance sheets; Cash flow; Financial accounting; Financial analysis; Financial
management; Financial planning; Intangible assets. Setting: Banking industry; High technology; Life
sciences; Petroleum industry; Pharmaceutical industry; Semiconductor industry; 2001. Length: 9p

• Companies in knowledge-intensive industries (pharmaceuticals, software) keep larger cash


balances than traditional capital structure models would predict because of the cost or lack of
external financing for their variable assets.
• Research shows that in times of financial distress (which can be triggered by the inability to
maintain research pipelines), knowledge-intensive industries lose far more enterprise value than
tangible-asset industries (petroleum).
• The authors propose a revised model of optimal capital structure that weighs the insurance value
of holding cash against the tax advantages of debt to the company’s enterprise value.
• The article then applies the revised model to a tangible-asset company and concludes with ways
how cash management should be integrated in business risk management.

Alternative: MCI Communications Corp.—1983 Bruce C. Greenwald; Wilda L. White


MCI Communications Corp. is faced with a large need for external financing to support rapid growth and
substantial uncertainty due to the AT&T antitrust settlement. The case illustrates the value of convertible
debt as a financing instrument in these circumstances.
Subjects Covered: Antitrust laws; Bonds; Debt management; Financing; Telecommunications; Uncertainty
Setting: District of Columbia; Telecommunications industry; $1 billion revenues; 1968-1983. Length: 14p

• Bestseller
• Explores the interaction of setting financing policy consistent with corporate strategy and
business environment.

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• Highlights challenges of predicting optimal capital structure and financing needs in times of
drastic industry change.
• Provides details on pros and cons of various financial instruments, including bond and warrant
packages, “junk” bonds, convertibles, and common stock.

Dividend Policy
5. Dividend Policy at Linear Technology Malcolm P. Baker; Alison Berkley Wagonfeld
In 1992, Linear Technology, a designer and manufacturer of analog semiconductors, initiated a dividend.
The firm increased its dividend by approximately $0.01 per share each year thereafter. In fiscal year
2002, Linear experienced its first significant drop in sales since its 1986 initial public offering. Sales
dropped by 47%, and profits fell by 54%. In the spring of 2003, CFO Paul Coghlan is deciding whether to
recommend yet another increase in dividends to lift Linear's payout ratio to 33.1%, high by the standards
of technology firms.
Learning Objective: To provide an introduction to payout policy and Modigliani and Miller's dividend
irrelevance proof. The particular setting allows students to consider why profitable technology firms, like
Cisco Systems, Microsoft, and Intel, used no debt, retained large cash balances, and preferred to return
cash to shareholders in the form of repurchases rather than dividends; how the tax and market
environment for dividends has changed over time; and the impact of the proposed dividend tax reforms
and market environment of 2003 on future payout policy.
Subjects Covered: California Research Center; Cash management; Dividends; Financial management;
Semiconductors; Taxation. Setting: California; Semiconductor industry; $500 million revenues; 2,500
employees; 2003. Length: 18p

• The case text provides background on recent trends in corporate, government and institutional
investor attitudes towards dividend payment.
• The case can be taught in one day, with sections on (a) Linear’s funding requirements; (b) the tax
and agency costs of keeping the cash; (c) the issues and mechanisms involved in returning the
cash to shareholders.
• Highlights the tax disadvantages of recapitalizing.
• The discussion of returning cash to shareholders walks through Modigliani-Miller assumptions
about signaling, agency, taxes, clienteles, stock options and market conditions.

Alternative: Sealed Air Corp.'s Leveraged Recapitalization (A) Karen H. Wruck; Brian Barry
Less than a year after Sealed Air embarked on a program to improve manufacturing efficiency and
product quality, the company borrowed almost 90% of the market value of its common stock and paid it
out as a special dividend to shareholders. Management purposefully and successfully used the leveraged
recapitalization as a watershed event, creating a crisis that disrupted the status quo and promoted
internal change, which included establishing a new objective, changing compensation systems, and
reorganizing manufacturing and capital budgeting processes.
Learning Objective: To provide a context in which students can explore how financing decisions affect
organizational structure, management decision making, and firm value. Can be used as an introductory
finance case in which the students apply basic cash flow forecasting techniques to explore alternative
dividend and capital structure decisions. For more advanced finance classes, the concept of free cash-

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flow, its effect on stock market prices and firm value, and the disciplinary role of high leverage can be
analyzed.
Subjects Covered: Capital structure; Change management; Control systems; Crisis management; Debt
management; Dividends; ESOP; Recapitalization. Setting: New Jersey; Packaging, carton & container
industries; mid-size; $385 million sales; 2,000 employees; 1989. Length: 21p

• Bestseller.
• Can be taught over one or two days. If a two-day plan is followed, then the first day would focus
on the mechanics of the special dividend, dividend policy in general, and calculating Sealed Air’s
debt capacity. The second day would touch on organizational issues, performance
improvements, and the B case.
• The turnover among Sealed Air’s institutional shareholders following the dividend illustrates the
different risk-return goals of shareholders.
• Provides a good exploration of the organizational impact of leverage.

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