Valuation for Mergers, Buyouts, and Restructuring, Second Edition

Chapter 6

Valuation with Changing Capital Structure

6.1 LEVERAGE CHANGES AND ENTERPRISE VALUE

This chapter examines the valuation of firms with changing capital structure. Temporary departures from a target debt ratio take place in the normal course of business because of internal changes or the lumpiness of external financing. Some departures are large and take time to correct. In principle, a firm may stick to its target debt ratio by continuously issuing or retiring equity and/or debt. However, a number of factors lead to departures from the company's desired target. They include economies of scale in financing that result in a relatively large issue of a particular instrument, acquisitions financed entirely with debt or equity, and increased indebtedness because of gradual deterioration of the business and its cash flow. Leveraged buyouts (LBOs) and some recapitalizations result in temporary high levels of debt. Some firms incur high levels of debt in order to repurchase their own shares and fend off unwanted takeovers; other recapitalizations are made to salvage a business in trouble. Another case of high level of debt to be reduced over time is project financing. Firms that in the past have embarked in significant debt reductions include Du-Pont, Eastman Kodak, Owens Corning, AT&T, 7-Eleven, and most LBOs. The valuation method presented in this chapter also applies to firms that plan to increase their debt ratio over time in order to maintain or increase their dividend payout ...