University of the Cumberlands Capital Structure & Dividend Pay Outs Questions

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The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy
of the company. The board discussed the optimal capital structure of 60
percent debt and 40 percent equity and the likely effect of the capital
structure on the company’s weighted average cost of capital (WACC) and
the firm value. During the meeting it came up that debt provides tax
benefits to the firm because interest is tax deductible whereas dividend
is not. Therefore, the debt ratio of 60 percent was considered
acceptable. However, Gregg, the CFO of the company, stressed that debt
can put pressure on the firm because interests and principal payments
are fixed obligations that the company must pay, no matter the profit of
the company. He stated that if these obligations are not met, the
company may risk some sort of financial distress and files for
bankruptcy. Gregg continued to explain that if the company files for
bankruptcy there are direct and indirect costs that Baldwin must incur.

Milosvoski, a board member suggested that there are ways to reduce the
cost of debt by hiring an expert to handle the company’s debt agreements
between the shareholders and bondholders. He stated that protective covenants are
incorporated as part of the loan agreement and must be taken seriously
because a broken covenant can lead to default. He mentioned negative covenant and a positive covenant as types of protective covenants the company should take seriously.

Miller, another board member stated that one reason bankruptcy costs
are so high is that different creditors and their lawyers contend with
each other. He suggested that if debt can be consolidated, or if
bondholders can be allowed to purchase stock of the company bankruptcy
cost will be reduced. In this way, stockholders and debtholders are not
pitted against each other because they are not separate entities. He
cited examples in Japan where large banks generally take significant
stock positions in the firms to which they lend money.

The employee representative on the board, Ms. Johnson used the free cash flow hypothesis
to state that firms with high free cash flow are very likely to
undertake more wasteful activity which has a serious implication for
capital structure. Since dividends leave the firm, they reduce free cash
flow. Thus, according to her, an increase in dividends should benefit
the stockholders by reducing the ability of corporate managers to pursue
wasteful activities. She continued that since interest and principal
also leave the firm, debt can reduce free cash flow and wasteful
spending. But because corporate managers are not legally obligated to
pay dividends, she suggested that debt of the company be increased.

Suzuki, director of Public Relations and a board member was of the view
that determining optimal debt-equity ratio is not an easy task and
varies across industries so Baldwin should follow the rules of the pecking-order theory when financing capital projects.
No agreement was reached on the company’s capital structure, but the
CEO and Gregg believed that the 60-40 debt-equity capital structure will
minimize the cost of capital and improve the firm value.

board is retaining you as the financial consultant to assist with the
company’s capital structure and dividend payout decisions. The Chairman
of the board wants you to address the following questions:

  1. List 5 reasons to support Ms. Johnson’s free cash flow hypothesis claim
    that debt of Baldwin Inc. be increased. The reasons you give should
    focus on advantages of debt that can convince the board to increase the
    debt-to equity ratio of the company.
  2. State 5 examples of direct and indirect costs associated with bankruptcy that Gregg stated in his presentation to the board.
  3. Give two examples each of positive covenant and negative covenant as stated by Mr. Milosvoski in his protective covenant explanation.
  4. Explain the rules of pecking-order theory of capital structure as suggested to the board members by Mr. Suzuki, the director of Public Relations.
  5. Do
    you agree with Ms. Johnson’s statement that an increase in dividend is
    beneficial to the stockholders of Baldwin? Explain with three reasons
    why or why not.
  6. Baldwin
    Inc. is planning to pay dividends of $3 per share to shareholders in
    2020 (total dividend is $3 million). But because of personal taxes on
    dividend income, the company wants to postpone the dividend to next 5
    years when they believe a new tax legislation will be passed by Congress
    to give tax exemption on dividend and investment income. Suggest three alternatives to the board of how the available cash can be used in place of the dividend.
  7. Baldwin Inc. wants you to help them prepare a dividend policy
    which will guide the first dividend payout of the company in 2025. List
    five characteristics of a sensible dividend policy you want the board
    to know.

Prof. Angela


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