Category Archives: debt/liabilities

Corporate financial policy deciphered (1)

At a recent TMT conference I attended, a speaker from Moody’s characterized the target capital structure of investment-grade Telecom operators as a Net Debt-to-Ebitda ratio of between 2.0x and 3.0x.[1]

To remain within the target interval, firms need to balance their investments and payout policies with cash available from operations.  A ratio above 3.0x negatively affects lenders’ attitudes, making debt more restrictive and expensive. A ratio below 2.0x raises shareholders’ concerns that cash might be wasted in imprudent acquisitions and value-destroying projects.

As the figure below indicates, companies actively manage their finances in an effort to stay within the designated interval.

By meeting shareholders’ remuneration expectations and their obligations to creditors, firms are able to keep key providers of capital pacified. Additional efforts to achieve the absolute optimal capital structure only translate into unnecessary and costly adjustments. Thus, the fact that firms do not rebalance capital structures frenetically does not mean that firms are inattentive. Rather, the apparent passiveness reveals a lack of concern with some variation as long as the Net Debt-to-Ebitda ratio stays within the target range. But when the ratio approaches the critical limits, firms tend to become sensitive and act to correct deviations. Market conditions then determine whether these corrections happen quickly or slowly.

[1] Moody’s includes operating leases and pension liabilities in gross debt.

Hedging and the Terms of Debt

A new academic research paper by Campello, Lin, Ma and Zou takes a stab at documenting the impact of corporate hedging on the terms at which the company can borrow money in the syndicated loan market. (older version available here for free) For the last two decades, syndicated loans have been the largest source of funding for corporations, larger than the bond issuances. The study looks at hedging and loans at 1200 firms over the years 1996-2002. The authors advertise the paper as a look at one important channel through which hedging may add value to companies.

The findings are…
1. Increased hedging lowers the loan spread.
Companies with average usage of hedging derivatives are charged loan spreads that are 28% lower than non-hedgers. The impact is stronger for companies with higher probability of bankruptcy (lower Z-scores) and for companies with higher growth opportunities (higher market-to-book ratio).
2. Increased hedging lowers the probability that a loan will include a covenant restriction on investments.
An average hedger has 20% less probability of facing investment restrictions than a non-hedger. In addition, a one-standard deviation drop in Z-score increases the likelihood that the lender will impose a capital expenditure restriction on a non-hedger by 15.5%, compared to a statistically insignificant 5.2% for a hedger.
3. Increased hedging increases investment spending by 13% over the mean level.

Three comments.

First, while the paper’s results are surely important, the discussion of the impact on firm value is very confused. For example, an effort is made to decompose the portion of the loan spread that reflects an adjustment in the nominal rate in order to compensate for the expected loss of default, and the portion that equals the true economic rate of return. The authors label this latter variable the “true cost of debt”. But it is not a deadweight cost, so whether hedging reduces this true cost or not does not answer the question of whether hedging raises the value of the firm. Assuming a Modigliani-Miller world, hedging lowers the systematic risk of the firm and therefore its expected return on capital. The return on debt will fall, accordingly. But this leaves firm value unchanged. We can abandon the Modigliani-Miller assumption and recognize that hedging may somehow reduce deadweight costs and therefore does increase firm value. But still, this reduction in deadweight cost isn’t measured by the authors’ “true cost of debt” variable.
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