BUSI 685 Week 3 DB Forum 2 Example

Discussion Board Forum 2: Thread and Replies

BUSI 685 Financial Management, Discussion Board Forum 2 (thread and two replies)

Thread by [Student Name]

The forum prompt, the company and the classmates are composites standing in for the course's own; the textbook, Scripture and research cited are real, and the requirements follow Liberty's public course guide for BUSI 685.

Thread

The prompt describes a composite maker of industrial valves earning $400 million a year before interest and taxes, with no debt and steady demand from utilities. Activist shareholders want it to borrow $1.5 billion and use the proceeds to repurchase stock. Management says debt is risky and unnecessary, pointing to the 2009 recession, when orders fell by a third for two years.

Brealey et al. (2017) begin with Modigliani and Miller's result that, in perfect markets, the split between debt and equity does not change the total value of the firm; borrowing only reshuffles the claims on the same cash flows. Debt matters because markets are not perfect. Interest is tax-deductible, so at the 21 percent federal corporate rate, $1.5 billion borrowed at 6 percent would cost $90 million a year in interest and save about $19 million a year in federal taxes. Against that sits the cost of financial distress, which rises as debt grows relative to the firm's ability to service it. With $1.5 billion of debt, interest coverage would be about 4.4 times in a normal year, but a two-year slump like 2009 could cut it below 3, close to the level at which lenders tighten terms and customers start to ask questions.

Evidence suggests firms like this one borrow too little. Graham (2000) estimated that the capitalized tax benefit of debt equals about 9.7 percent of firm value for the typical firm, or as low as 4.3 percent after personal taxes, and found, paradoxically, that large, liquid, profitable firms with low expected distress costs use debt most conservatively. Our company fits that description. Myers (1984) offers one explanation in his pecking order: managers rank retained earnings ahead of borrowing and borrowing ahead of new shares, partly because outside money comes with a signal. That explains why a cash-rich firm stays unlevered, but not why it should.

Scripture is often cited against borrowing. Paul tells the Roman church to leave every debt settled except the continuing debt of love (English Standard Version Bible, 2001/2016, Romans 13:8). The verse before it (Romans 13:7) has just instructed believers to give everyone what is due, whether taxes, revenue, respect or honor. The command is to leave no obligation unpaid, not to avoid every contract. Debt a firm can comfortably service is an obligation it can honor. The biblical concern is with debts that cannot be repaid, not with the existence of a loan.

I would recommend moderate borrowing, perhaps $600 million, which interest coverage of more than ten times could easily support, with a board policy capping debt at two times operating income so that the firm never borrows beyond its ability to repay.

Reply to Brandon

Brandon, you argued that because interest is tax-deductible, the company should borrow as much as lenders will allow. The tax shield is real, but its value per dollar declines. Graham (2000) found that a typical firm could double its tax benefits by issuing debt until the marginal tax benefit begins to decline, which implies that beyond that point, more debt adds less and less. Brealey et al. (2017) describe what pushes back as debt grows: as the debt ratio rises, so do the expected costs of financial distress, including lost customers and suppliers who fear a failing supplier, and the conflicts between shareholders and creditors that distort investment. For a valve maker whose utility customers sign long contracts partly because they trust its stability, distress costs could arrive well before bankruptcy. Borrowing to the limit would trade a modest tax gain for a real risk to the business, and the tax gain itself shrinks in a downturn, when there is less income to shelter. Would you set the limit by lenders' willingness or by the company's own coverage target?

Reply to Naomi

Naomi, you used Myers's pecking order to argue that the company should not borrow because it already has internal funds. Myers (1984) does describe that preference, and his reasoning is persuasive: managers who know more than investors avoid issuing securities that the market might misprice. But the pecking order explains what firms tend to do, not necessarily what maximizes value. Brealey et al. (2017) present it alongside the trade-off theory, in which each added dollar of debt buys a tax saving and adds to expected distress costs until the two offset, and they note that neither theory explains all corporate behavior. Here the pecking order's main concern, the information cost of issuing securities, is small for borrowing: a stable, profitable firm can issue investment-grade debt without signaling much about its value. The activists' case rests on the trade-off theory, and the company has room on that scale. Keeping the cash and adding moderate debt would still leave management with the financial slack the pecking order values. Would you accept some borrowing if it were tied to a firm repayment plan?

References

Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of corporate finance (12th ed.). McGraw-Hill Education.

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Graham, J. R. (2000). How big are the tax benefits of debt? The Journal of Finance, 55(5), 1901-1941. https://doi.org/10.1111/0022-1082.00277

Myers, S. C. (1984). The capital structure puzzle. The Journal of Finance, 39(3), 575-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x