Corporate Financing Strategies

Section 1: Choosing The Firm’s Financial Structure

Practice questions
Dr. Williams

1. In company financing, owners’ equity serves what two roles?

assurer une partie du financement et renforcer la garantie des prêteurs

(to fund a portion of the firm’s capital needs, and reduce risk for creditors)

2. A company with lots of growth opportunities would be more likely to issue short, medium, or long-
term debt? Why?

à court terme afin de pouvoir se refinancer à des meilleures conditions au fur et à mesure que les
opportunités de croissance deviennent des investissements rentables et la valeur de l’entreprise
progresse
(short term, in order to maintain financing flexibility and be able to refinance with cash generated
from profitable investments as the company grows)

3. Is it best for a company to always finance the business through owners’ equity?

Non, moins elle devient risquée, plus elle peut être financée par dettes. Les start-ups présentent
trop de risque pour être financée par la dette.
(No, as shown in class, as firm business risk declines, firms may take on financial risk. Start-ups
are naturally too risky to have debt financing)

4. Can an entrepreneur seeking to opportunistically finance his/her business maintain this strategy
over the long-term ?

Non, une stratégie industrielle ne peut pas attendre l’arrivée d’opportunités de financement
(no, it’s not realistic to time the market with your financing decisions. The firms funding needs will
rarely match up with attractive opportunities to sell debt or equity)

5. A hotel company can refinance through debt more easily than a technology firm. Why?

Car il détient des actifs (bâtiments, terre, fonds de commerce) qui ont une valeur en dehors de
l’exploitation et peuvent être donnés en garantie des emprunts. Tech: mutations incessantes –
prévisions de flux hasardeux.
(A hotel possesses real assets with good resale value. A Tech firm possesses intangible assets with
little resale value)

6. Nestle Waters can more easily refinance its business than Constellation Pharmaceuticals. Why?
 Flux plus prévisibles que ceux d’un groupe pharmaceutique dont les brevets expirent régulièrement
(Cash flow are much more predictable for Nestle. A pharma company has an irregular flow as
patents expire regularly)

7. Can Air France rely on debt financing despite its high fixed costs?

Oui, elle contrôle deux actifs qui ont de la valeur sur le marché secondaire: les avions et les
droits d’atterrissage dans les aéroports
(Yes, Air France has valuable, salable assets that would reassure a creditor, despite the high fixed
costs: the planes and airport slots)

8. A company has €600M in equity book value. Assume three scenarios for the company:
• market value of equity is 50% of book (accident de parcours),
• market value of equity is 100% of book (average company)
• market value of equity is 200% of book (champagne and caviar)

The company wants to raise new capital, corresponding to one-third of its current owners’
equity. Complete the following table.

Bad company Average company Great company

Book value of equity
Market value of equity
Capital raise
% Dilution of shareholders
% Growth of equity book value

What is the relationship between the sacrifice of owners, in terms of dilution of control, and
growing the firm’s equity capital?

Bad company Average company Great company

Book value of equity 600 600 600
Market value of equity 300 600 1200
Capital raise +100 +200 +400
% Dilution of shareholders 25% 25% +25%
% Growth of equity book value 16.7% 33.3% 66.6%

When the market value of equity is superior to the book value of equity, a similar effort on the
part of owners in giving up control reaps much larger growth in owners’ equity. A capital raise
when MV > BV can greatly strengthen a firm’s financial position, while only modestly reducing
control of current owners.
9. Consider the excerpts from McDermott’s financial statements below.

Item 2025 2020

Total Revenue €200M €325M
Net Income €-25M €40M
Basic EPS €-0.10/ sh €0.35/ sh
Payout ratio 0.0 0.50
Credit rating B BBB

In 2020, McDermott raised €100M in equity capital. In retrospect (à posteriori), how would you
evaluate in 2025 the explicit cost of this equity capital for the firm?

The firm has suffered a very bad period over these 5-years. It likely that the equity issued in 2020
has a negative return and we can see from the pay-out ratio that the dividend was cut to €0. For the
firm, the explicit cost of this equity raise was close to nul – the firm has paid the investor little or no
dividends (with falling profits) and there was no opportunity cost in selling the equity too cheap. On
the contrary, it turns out the firm made a “good deal” in selling over-priced equity, while the
investor was the big loser.

10. Sanchez Energy issued a 10-year bond in 2020, raising $200M. The bonds had a face value of
$1000 and a nominal (coupon) rate of 5% annually. The bond indenture includes a Step-Up
Covenant which states that the interest rate on the bond will double if Sanchez’s credit rating falls
to junk status.

In 2025, Sanchez’s credit rating was cut from AA to BB. Assuming that Sanchez is able to meet all
interest payments until 2030, what will be the total cost of the bond issue for the firm?

Step-up covenants increase coupon interest rate on bonds if the issuer’s credit deteriorates. Below
BBB, the firm’s credit is considered junk.

In the first 5 years, the annual interest payments were $10M per year (5% x $200M). In year 2025,
the annual coupon interest rate jumps to 10%. In the last 5 years, the annual interest payments were
$20M per year (10% x $200M). The total interest cost of the bond issue was therefore $150M.