This dissertation has been 65-1205 microfilmed exactly as received
MOCK, Edward Joseph, 1934- AN EVALUATION OF BORROWER RISK IN INDUSTRIAL COMPANIES EMPLOYING CONVERTIBLE SUBORDINATED DEBENTURES. The Ohio State University, Ph. D ., 1964 Economics, commerce-business
University Microfilms, Inc., Ann Arbor, Michigan AN EVALUATION OF BORROWER RISK
IN INDUSTRIAL COMPANIES EMPLOYING
CONVERTIBLE SUBORDINATED DEBENTURES
DISSERTATION
Presented in Partial Fulfillment of the Requirements for the Degree Doctor of Philosophy in the Graduate School of the Ohio State University
bY
•Edward Joseph Mock, B. S., M. B. A.
*****
The Ohio State University
1964
Approved b,
Adviser Department of Business Organization ACKNOWLEDGMENTS
Sincere appreciation is extended to the following persons:
-'Professor Elvin F. Donaldson, who provided guidance from the beginning of this project and who gave willingly of his time toward the completion of it;
Professors George S. Goodell and Clayton R. Grimstad, for their understanding and assistance as members of my dissertation committee. VITA
January 28, 1934 Born - Wilkes-Barre, Pennsylvania
1955 ...... B.S., Kingfe College
1955-1957. . . . Assistant to Professor Francis J. Calkins Marquette University /
1957 ...... M.B.A., Marquette University
1957 ...... Direct commission in the United States Army / Finance Corps
1960 ...... Anna M. Dice Memorial Fellow, Ohio State University
1962 - Present . Instructor in Finance, Pennsylvania State University
PUBLICATIONS
Articles
"Pennsylvania1s Problem of Bank Management Succession," Pennsylvania Business Survey, (February, 1964), pp. 4-6.
With Joseph F. Bradley. "Changing Patterns of Savings in Pennsyl vania, 1944-1961," Pennsylvania Business Survey, (April, 1963), pp. 5-6.
With Joseph F. Bradley. "See How They've Grown: Savings and Loan Associations More than Double the Growth Rate of Time Depos its in Commercial Banks," Pennsylvania Business Survey, (September, 1963), pp. 8-10.
With Joseph F. Bradley. "The Contributions to the Nation's Social System by the Investment Bankers Association," The Commercial and Financial Chronicle, (January 31, 1963), pp. 8-9.
Books
Readings in Financial Management (Scranton, Pennsylvania: Inter national Textbook Company, 1964).
Short Problems in Business Finance and Financial Management (Scran ton, Pennsylvania: International Textbook Company, 1964). FIELDS OF STUDY
Finance. Dr. Elvin F. Donaldson
Banking. Dr. Frances Quantius
Statistics. Dr. L. Edwin Smart
Economics. Robert D. Patton TABLE OF CONTENTS
Page
ACKNOWLEDGMENTS...... ii
VITA ...... iii
LIST OF TABLES...... vii
LIST OF ILLUSTRATIONS...... ix
Chapter
I. AN INTRODUCTION TO THE RISK DECISION...... 1
Statement of the Problem and Purpose of the Study...... 1 Scope of the Study...... 3 Literature Survey ...... 6 Organization of the Study...... 7 Research Methodology...... 8 Sample Selection...... 11
II. RELATIVE IMPORTANCE OF SELECTED DEBT OFFERINGS IN THE UNITED STATES, 1950-1962...... 20
III. MANAGEMENT'S EXAMINATION OF ALTERNATIVE SECURITY ISSUES...... 36
Managerial Evaluation Criteria...... 36 Common Stock...... 38 Internal Financing...... 39 Preferred Stock...... 43 The Incentive to Borrow ...... 45 Borrowing Versus Internal Financing...... 46 Borrowing Versus Common Stock Financing...... 47 Convertible Subordinated Debentures...... 50
IV. SOURCES FOR THE FORMULATION OF RISK OF BORROWING RULES IN THE COMPANIES INVESTIGATED...... 66
Dependent Standards...... 67 Independent Standards...... 74 Table of Contents
Chapter Page
V. BORROWING DECISION RULES EMPLOYED BY MANAGEMENT 78
External Risk Decision Standards...... 79 Internal Continuous Borrowing Risk Decision Standards...... 82 Discontinuous Borrowing Risk Decision Standards...... 88 Continuous and Discontinuous Borrowing Approaches to Risk...... 91 Other Risk Decision Factors...... 93
VI. A PROPOSED RISK STANDARD: CASH FLOW ANALYSIS...... 97
The Determinants of Cash Flow...... 98 Recession Behavior of the Determinants of Cash Flow ...... 103 The Cash Balance...... 106 The Problem of Timing...... 107 The Anticipated Limit...... 109 Current Condition...... Ill Assembling the Data...... 112 Application of Cash Flow Analysis...... 115 Cash Insolvency...... 120 Cash Inadequacy ...... 122 Opinions of Others...... 126 Limitations of the Data...... 128 Managerial Influence on Cash Insolvency...... 130 The Lease Contract ...... 132 Liquidity and Flexibility...... 133
VII. CONCLUSIONS. ... 134
Convertible Subordinated Debentures...... 136 Measurement of Risk of Senior and Subordinated Debt...... 137
BIBLIOGRAPHY...... 144
vi LIST OF TABLES
Table Page
1. Total Public Offerings and Private Placements of Debt Securities...... 21
2. Total Public Offerings of Industrial Debt Securities...... 22
3. Total Public Offerings and Private Placements of Subordinated Debt Securities...... 23
4. Total Public Offerings and Private Placements of Convertible Debt Securities...... 24
5. Total Public Offerings and Private Placements of Convertible Subordinated Debt Securities...... 25
6. Total Public Offerings and Private Placements of Industrial Convertible Subordinated Debt Securities...... 26
7. Annual Dollar Volume and Number of Issues of Convertible Subordinated Debt Securities as a Percentage of Total Public Offerings and Pri vate Placements of Debt Securities...... 29
8. Annual Dollar Volume and Number of Issues of Industrial Convertible Subordinated Debt Securities as a Percentage of Industrial Debt Securities ...... 31
9. Annual Dollar Volume and Number of Issues of Industrial Convertible Subordinated Debt Securities as a Percentage of Convertible Debt Securities...... 34
10. Range of Possible Combinations of the Adverse Factors in Cash Flow Analysis...... 114
11. Estimated Net Cash Flows Associated with the Adverse Limits of Recession Experience...... 117
vii List of Tables
Table Page
12. Results of Cash Flow Analysis as Shown in Table 11, Regrouped in Order of Increasing Net Cash Flows...... 119
13. Cash Solvency at the Limits of Adversity ...... 121
14. Cash Adequacy at the Limits of Adversity...... 125
viii LIST OF ILLUSTRATIONS
Chart Page
1. Annual Dollar Volume and Number of Issues of Convertible Subordinated Debt Securities as a Percentage of Total Public Offerings and Private Placements of Debt Securities...... 30
2. Annual Dollar Volume and Number of Issues of Industrial Convertible Subordinated Debt Securities as a Percentage of Industrial Debt Securities...... 32
3. Annual Dollar Volume and Number of Issues of Convertible Subordinated Debt Securities as a Percentage of ConvertibleDebt Securities...... 35
4. Frequency of Sales Contractions in Recession Periods...... 110
Example
1. Broadening the BorrowingBase by Employing Subordinated Debt and Junior Subordinated Debt...... 62
ix CHAPTER I
AN INTRODUCTION TO THE RISK DECISION
Statement of the Problem and Purpose of the Study
A managerial desire for future solvency and profitability of
a business renders the percentage relationship between debt and equity
in the capital structure of primary financial importance. Because
of its contractual commitment to interest payments and repayment of
principal to creditors, the employment of borrowed funds results in
the opportunity for profit or the possibility of loss.
At present, the choice between debt and equity in the capital
structure is evaluated on the basis of suitability, profitability,
risk, flexibility and timing.*' To date, greater progress has been
made in the appraisal of suitability, profitability, flexibility 2 and timing than in that of risk. A systematic operational approach
to risk measurement of long-term debt has yet to be provided. This
is the problem that this study will attempt to solve. The purpose
Of the study is to provide an operational approach to risk measure
ment of long-term debt in industrial companies employing convertible
subordinated debentures.
Robert W. Johnson, Financial Management (2nd. ed,; Boston: *Allyn and Bacon, Inc., 1962), pp. 141-155.
^Ibid., p . 151.
1 2
The debt decision is affected by uncertain future conditions.
While providing long-term investment capital, the debt contract commits a business to certain financial obligations extending beyond a period for which confident forecasts can be prepared. Neverthe less, management must formulate assumptions concerning future 3 profitability and the risk of cash insolvency. The creation of additional contractual cash outflows accompanied by the uncertain
timing and amount of cash inflows increases the risk of cash insol vency. Risk-of-debt thus becomes proportional to the magnitude of cash outflows for debt servicing (interest and principal payments).
The method chosen for the appraisal of risk-of-debt is the estab
lishment of borrowing limits in terms of the magnitude of cash out
flows. Therefore, the decision-making process will be facilitated by the determination of an appropriate limit to the amount of risk associated with long-term debt.
An intelligent appraisal of the risk decision is presently obstructed by existing financial analysis techniques which are not
directly adaptable to an evaluation of the risk associated with long
term debt. The development of a logically defensible and practical
common basis for assessing the risk-of-debt is the primary contribu
tion of this study. Gash flow analysis is presented as an improved
Insolvency describes the financial position of a business which is unable to meet its-debts as they become due. However, in solvency, as defined in the Bankruptcy Act, refers to a situation in which the assets, at fair valuation, are insufficient to pay the debts. We will use the former definition and hereafter refer to it as cash insolvency. 3 technique for the measurement of risk. Cash flow analysis is an intensive examination and evaluation of inflows and unavoidable nonpostponable outflows of cash in an attempt to appraise the risk of cash insolvency associated with various borrowing limits. The analysis provides the financial manager with information regarding the adverse limits of cash balances. This information enables the
financial manager to measure the risk of cash insolvency and indi cates the impact of debt servicing on risk. While designed primarily as a tool of financial analysis, cash flow analysis may be useful to the practitioner seeking a better conceptual framework for analysis of the risk dimension of long-term debt.
A secondary objective of this study is to examine the alter native sources of long-term funds, emphasizing the use of convertible
subordinated debentures. A sample of large corporations in selected
industries is studied to determine the underlying factors in a decision to incur debt.
Scope of the Study
The term "risk" when employed in various contexts has diverse meanings dependent upon one's background and experience. Generally,
risk denotes the possibility of occurrence of an adverse event or
effect. With respect to long-term debt, risk is the probability of
adverse effects resulting from a commitment to make cash payments,
certain.in amount and timing, under uncertain future financial 4 circumstances. These adverse effects may range from a modest in crease in the emotional strain of management to the event of bank ruptcy. They include such considerations as negative income effects and interference with flexibility in future financing.
In order to examine risk-of-debt in a simple and familiar framework, this study focuses on the limits of adversity, that is, the possibility that all outstanding and contemplated long-term debt could result in cash insolvency. This oversimplification is justifiable because businessmen commonly evaluate debt limits in terms of this ultimate hazard. * Risk-of-debt financing is characterized by an attempt to balance the amount and timing of total cash inflows and outflows.
Viewed in this manner, any measurement of the risk-of-debt begins with an appraisal of expected variations in total cash inflow and of management's influence over total cash outflows. Management can then ascertain the extent to which the probability of cash insolvency is increased by the issuance of long-term debt.
Because the measurement of risk associated with debt is de pendent upon forecasting cash flows, any such analysis must be in terms of the circumstances of an individual business. Moreover, any conclusions can be applied with confidence only to the company under consideration. Thus, the merits of this study must be restric ted to the method of analysis rather than to the production of quantitative standards. 5
In an analysis of debt and equity, certain distinctions re garding future cash obligations are made on a legal and contractual basis. Payments under a debt contract are treated as mandatory, whereas those under an equity contract are considered discretionary.
The primary purpose of this study, however, is to aid decision-making in the area of long-term debt financing. Therefore, the legal clas sification is inappropriate because management treats dividends to common and preferred stock, research and capital expenditures as nondiscretionary disbursements in the short-run. This will be re- 4 ferred to as the risk of cash inadequacy. Obviously variations in assumptions can have major implications for cash flow analysis and its subsequent applications.
The determination of individual company debt limits is not within the scope of this study, because the debt decision is a function of many considerations in addition to risk. Moreover, willingness to assume risk, the relative importance of the possi bility of loss as opposed to the opportunity for gain, is essen tially a subjective decision and cannot be quantitatively measured.
Cash inadequacy, less severe than cash insolvency, describes a temporary interruption of expenditures regarded as mandatory by management policy. Cash inadequacy thus becomes a warning indicator of the impending possibility of cash insolvency. I 6
Literature Survey
The primary contributor to the general body of theoretical knowledge in the area of borrower risk of long-term debt has been
Gordon Donaldson in Corporate Debt Capacity, published in 1961 by the Graduate School of Business Administration, Harvard University.
In the March, 1962, issue of the Harvard Business Review under the title "New Framework for Corporate Debt Policy" Professor Donaldson restated the basic theoretical axioms regarding debt capacity which were included in Corporate Debt Capacity.
The present study differs from that of Professor Donaldson in that it is attempting to provide a useful operational guide to borrower risk measurement of long-term debt. In addition, the in vestigation is limited to industrial companies employing convertible subordinated debentures. Professor Donaldson provided the theoreti cal foundation for the development of this practical approach to risk measurement. The research in this study represents an ex- tention of the body of general knowledge regarding the borrower risk of debt in industrial companies.
The primary contributors to the body of knowledge in the area of convertible subordinated debentures have been C. James Pilcher and Robert W. Johnson. In Raising Capital with Convertible Securities, published by the School of Business Administration, University of
Michigan in 1955, Professor Pilcher discusses the theoretical and practical implications of convertible debentures. In an article titled "Subordinated Debentures: Debt That Serves as Equity," in 7
The Journal of Finance in March, 1955, Professor Johnson presented the theoretical and practical ramifications of subordinated deben tures. The writer's interest in the materials of Messrs. Pilcher and Johnson is limited to a verification of interview findings re garding management attitudes toward alternative sources of funds.
Organization of the Study
The study is divided into three parts. Part one appraises the importance of recent issues of selected debt offerings. The examination centers upon industrial convertible subordinated deben tures. The second portion, a study of risk and related financial policies, is descriptive of business practices and policies of risk- bearing capacity. While it is not a major objective to observe and report financial policy, risk cannot be fully understood without some appreciation of management thought concerning alternative sour ces of long-term funds.
With these findings, the study proceeds to a consideration of
the concepts and attitudes which underlie management decisions to
employ long-term debt. Of primary concern is the risk associated with debt, management's concept of risk and its method of dealing with it. While considering the reasons for management's actions,
the evaluation is extended to include the practices and risk policies
of investors.. The means employed by financial managers to limit the
potential disadvantages of debt are examined. The process becomes 8 one of minimizing the associated hazards. Interest centers on op erational standards which governed management's decisions.
Part three, an evaluation of risk decision standards and a proposal for improvement, is largely analytical. Included is an evaluation of the risk policies and standards in terms of the valid ity of the underlying assumptions, their logical consistency and their reliability in producing the desired decisions. Particular attention is devoted to practices concerning restraints on the risk associated with fixed-charge sources of funds.
This appraisal of business practice with regard to the deter mination of risk limits is followed by the description of a cash insolvency approach to the problem. Intensive experience of the pattern and limits of variation of the determinants of cash flow enables the analyst to ascertain probable lower limits of the cash balance under varying assumptions. The establishment of these limits assists management in deciding the extent to which incremental fixed cash outflefts'should be assumed. The cash insolvency method is illustrated by an application of the proposed risk standard to an office equipment company.
Research Methodology
An appraisal of any method for evaluating borrow risk requires an awareness of current business thinking and practice. To accomplish this purpose, the financial experience of seventeen companies was 9 analyzed. Five of these in the office equipment industry comprised a pilot group in which research questions and techniques were tested and improved. Field research then proceeded to a core group of twelve companies, four from each of three industries--aerospace man ufacturing, chemicals, and petroleum refining. The contributing businesses will remain anonymous to encourage maximum freedom in the release of information and accurate reporting on the results obtained.
The first stage in the collection process was assembly and analysis of all published data for companies in the office equipment industry, including annual reports and financial statements, pros pectuses, reports to the Securities and Exchange Commission and the publications of financial services. The second stage consisted of an interview with top financial officers. With permission, the principal investment banker concerned with the issue was interviewed.
These interviews disclosed the underlying attitudes toward risk in that segment of the capital market with which an individual business was negotiating and their effect upon the borrower 1s viewpoint. The interviews were not intended as a comprehensive study of the lending and investing practices of these institutions. As such, they were
confined to the twelve investment bankers associated with the core
sample of borrowers. Because the purpose of the interviews was a
consideration of borrower risk policy, attitudes of investment bank
ers were not considered independently of their circumstances and objectives. 10
The basic areas of investigation may be summarized as follows:
(1) A factual history of the debt and cash flow experience of. the company.
(2) The attitudes of management toward the use of long-term debt as an alternative to other sources of permanent capital.
(3) Individual management approaches to the standards em ployed in a decision to issue long-term debt.
(4) Individual management approaches to the appraisal of risk associated with debt.
(5) Willingness to assume risk-of-debt financing as expressed in established debt policies and concepts of debt limits.
With this information, current concepts, attitudes and prac tices regarding debt may be generalized. Since the basis of sample selection does not provide a statistical measure of confidence, the results are suggestive rather than conclusive indications of behavior.
The objectives of the study and the confidential nature of the de sired information limited the utility of a predictive sample.
However, every effort was made to prohibit bias.
Since it was neither practicable nor essential that the collection and analysis of historical financial data encompass the entire sample, efforts were confined to companies in the office equipment industry. The significance of individual observations is secondary to an illustration of the methodology involved. 11
Sample Selection
The primary consideration in sample selection was to provide an opportunity for examination of risk associated with debt against the background of individual characteristics of cash flow. In se lecting an area of business activity, the sample was confined to industrial companies because of a widespread tendency by investors to treat this group as an identifiable risk category distinct from public utilities, transportation, banking and finance. This is evidencedby the grouping of statistical and financial information, the organization of investment and research departments and the acceptance of standardized criteria of risk-bearing capacity.
In selecting industries, the essential requirements were a substantial amount of debt outstanding and sharp contrasts in the characteristic behavior of the principal determinants of cash flow.
Industrial firms employing convertible subordinated debentures
/ satisfy both requirements. The debentures themselves fulfill a dual issuer purpose. While possessing the characteristics and ad vantages of a debt instrument, subordinated debentures also serve to broaden the borrowing base for future debt.
The following reasons support the selection of firms with convertible subordinated debentures outstanding. Managerial willing ness to accept the risk-of-debt is evidenced by the magnitude of senior debt present in the capital structure before subordinated debentures are actively contemplated and subsequently issued. Such 12 willingness is indicative of some appraisal of risk. In addition, every firm interviewed anticipates further issuance of senior and subordinated debt which would, of course, increase risk. Moreover, financial theory states that management includes the conversion fea ture in a debt contract in order to raise residual equity funds at a price above that of the current market. The convertible feature also represents management recognition of an attempt to reduce the risk of a contractual cash outflow associated with debt. By promoting conversion, management is attempting to replace a contractual cash outflow with a discretionary one.
Although finance companies originated and widely employ sub ordinated debentures, they have been excluded from consideration.
Because finance companies possess relatively stable, controlled and accurately forecasted cash flows, risk analysis is less difficult.
Further, their superb 20-year record of financing has strengthened investor's attitudes toward subordinated debentures. On the other hand, industrial use was minimal prior to 1955. Thus, industrial convertible subordinated debentures are a recent financing innovation.
It should be added, however, that although the study is confined to industrials, the method of analyzing risk-of-debt in terms of indi vidual patterns of cash flow is equally applicable to businesses in other areas.
In specifying the viewpoint of the borrowing company and in defining the basic risk as that of being "out of cash," all debt contracts may be similarly appraised. Further, since measurement 13 of risk will assume the form of total cash flow analysis, it is obvious that all debt, outstanding and actively contemplated, must be included.
Sharp contrasts in the characteristic behavior of the deter minants of cash flow was another requirement in industry selection.
In this regard, aerospace depicts one extreme in the variation of cash inflow, while the petroleum refining and chemical industries approach another. Thus, dissimilarities in debt outstanding and determinants of cash flow were observable. It is recognized that differences in the variability and uncertainty of cash flows and in risk-bearing capacity are relative rather than absolute. Unless,a precise technique is available, small variations are not readily apparent. The proposed method is approximate, susceptible of fur ther refinement and best illustrated by situations possessing the possibility of significant differences.
Comparable cash flow structures within industries were also essential. Cash inflows were subject to continuous modification, largely uncontrollable, at least in the short-run, and considerably uncertain in amount and timing. Categories of expenditures were similar and major obstructions to the rapid circulation of funds in the form of specialized plant and equipment, inventory in process of transformation and the collection of cash for goods delivered were encountered. Likewise, all industries relied upon spontaneous credit in the form of payables and accruals as a continuing offset to cash outflow. 14
The Industries
The aerospace industry exemplifies cyclical variation in sales and earnings. The nature of the product, a durable capital good of relatively high unit value, reflects in exaggerated form the fluctu ations of the general economy. Hence, the companies in this industry have experienced a series of sharp and prolonged contractions in cash inflow. For example, annual sales have contracted to a level
that is only 70 per cent of the sales of the previous peak period.
This contraction represents the maximum decline in sales during a
fifteen-year period.
Sample aerospace companies have survived due to such compensat
ing characteristics as advanced warning of a downswing. For example, rigidities in capacity to produce a product to order over an exten ded period may result in a substantial backlog of orders. Observa
tion of a downward trend prior to the actual decline,in cash inflow
from shipments of finished units is essential to orderly conservation
of cash. In addition, the production against orders from highly re
liable government accounts indicates that a substantial cash inflow
from declining inventories and accounts receivable results in unusual
cash liquidity rather than the hazard of cash insolvency. At such
times, the primary problem of the treasurer becomes profitable utili
zation of idle cash. Though the industry is not necessarily free from
risk, an intensive examination of the determinants of cash flow may
reveal a situation different from that indicated by the behavior of 15
sales or earnings. In contrast, the petroleum refining and chemical
industries enjoy greater stability in sales and cash inflow. The
adverse contraction of dollar sales is approximately 5 to 10 per cent
from the previous peak level.
Stability of inflow in the petroleum refining industry is fav
orable to a relatively high proportion of fixed outflows. Such sta bility is associated with sharp competition, particularly in the
refining and marketing of gasoline. Small declines in dollar volume
due to price cutting and the narrow margin between cash inflows and
outflows can complicate cash management.
Inventory and accounts receivable also influence cash flows
of the petroleum industry. Because refining is a continuous process,
daily production is closely tied to daily sales. When contraction
in dollar sales occurs in the form of price reductions rather than
in volume, the influence of cash throw-off from declining inventories
is insignificant. This is because a substantial portion of sales
made to retailers and ultimate consumers is on a cash or near-cash
basis.
A feature common to the petroleum and chemical industries is
the necessity for substantial plant and equipment expenditures to
benefit from recent innovations in cost-cutting equipment and plant
layout. Although financial theory considers capital investment as
discretionary, this competitive replacement can become nondiscretion-
ary as to amount and timing. The nature of the productive process 16
coupled with the need for expansion require large capital expendi
tures at irregularly spaced intervals.
While the chemical industry has generally enjoyed favorable profit margins, the petroleum refining industry has not been as for
tunate. However, profits and amortization charges, at times equal
to net profit in dollar amount for chemicals and exceeding profits
for petroleum refining, furnish a relatively large cash throw-off
from operations. This may provide a source of funds for expansion
and/or an important cushion against the effects of a decline.
In an industry with a considerable degree of homogeneity
there are observable characteristics of cash flow possessing some
degree of stability. These can be valuable in predicting the prob-
/' able limits of behavior of cash flows in periods of sales contrac
tion and can considerably influence their cyclical behavior.
However, these fundamental aspects are subject to gradual
change. For example, while the volume of accounts receivable will
fluctuate with sales, its effects on cash flow are circumscribed by
conventional credit terms, customer credit practices, proportions of
Cash and credit sales, the nature of demand and the structure of the
market. Within a short span of time these remain stable, but over
prolonged periods fluctuations may occur. These secular changes in
fundamental practices can profoundly affect cash insolvency.
After World War II, for instance, basic changes radically
altered the risk of investment in.the office equipment industry. In
flow from sales was stabilized by the development of a diversified /
17 product line and fixed long-term rental contracts. These changes provided the basis for expectations that future fluctuations in earnings and cash flows would be less severe. Hence, investors viewed certain office equipment stocks as possessive of investment merit.
The Companies
Four companies in each of three industries were selected for study. This arbitrary number afforded an opportunity for intensive analysis. In addition,, five companies in the office equipment indus try comprised a preliminary test sample.
To.qualify for the study, an extended period of experience in dealing with fluctuations in economic activity was required. Such firsthand experience was an essential prerequisite to any judgment of the nature of risk and/or any description of the behavior of cash flows. The above qualification obviously restricts the study to a consideration of mature companies. Although many of the companies have changed with the modification of industry or company policy, alterations have not been so sharp as to invalidate the usefulness of experience for future planning.
Only those companies having a history of substantial amounts of long-term debt in the capital structure were selected. Interviews were limited to financial officers experienced in employing debt.
Moreover, evidence of equal access to debt and equity sources of capital was essential. While these sources must not be precluded 18 by market or other circumstances, availability without limit is not implied. Availability of capital sources applies to internally gen erated equity capital and external acquisition through the sale of stock. Thus, profitability became a basic requirement. Therefore, each company must have an established public market for its common stock. All but one of the companies was listed on the New York Stock
Exchange, and eight of the companies on two or more of the organized exchanges. The issue not listed was actively traded over-the-counter.
Public ownership of stock assured the maximum availability of financial information. All sample companies were included in the manuals of the investment services and were subject to the disclosure rules of the Securities and Exchange Commission.
Any impression of "bigness" in the sample should not remain unqualified. There were, in fact, substantial variations in size among the companies within each grouping. The following data for
1961 illustrate assets and sales in terms of the arithmetic mean and the range.
Industry Total Assets Annual Sales
Mean Range Mean Range
(in millions of dollars)
Aerospace $ 397 $ 460 $1,076 $1,533
Petroleum Refining 1,135 1,237 818 936
Chemicals 562 865 497 740
Office Equipment 143 342 179 382 19
Thus, considerable variation is observable in competitive strength
among the companies in each industry and in their standing as inter
preted by investing institutions. CHAPTER II
RELATIVE IMPORTANCE OF SELECTED DEBT OFFERINGS IN THE UNITED STATES, 1950-1962
In an effort to determine the importance of industrial conver tible subordinated debentures, all corporate debt issues between 1950 and 1962 were examined. All data were derived from the semi-annual
"Corporate Financing Directory" appearing in the Investment Dealers'
1 _ Digest.
Tables 1 through 6 summarize the data gathered from the In vestment Dealers' Digest. To ascertain the importance of convertible subordinated debentures, the data have been recast in relative terms in Tables 7 through 9 and Charts 1 through 3. A brief examination of each table and chart follows.
The "Corporate Financing Directory" is published semi annually as Section II of the January and July issues of the Investment Dealers' Digest. Each issue surveys a six-month period of corporate financing for United States and Canadian companies. The Directory attempts to present all underwritten offerings as well as all available corporate private placements arranged by an investment banker or other selling agent. Since private placements are exempt from Securities and Exchange Commission publicity, a central source of accurate information is lacking. The Digest's compilation is based on public announcements and questionnaires sent to underwriters and institutional investors. To avoid duplication, the total amount of an issue contracted for is listed in the year the contract is concluded, although actual issuance of the securi ties may take place for several years. Inevitably some private placements were overlooked or incompletely reported. Nonetheless, this record is the most complete of its type available.
20 21
TABLE 1
TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF DEBT SECURITIES,.UNITED STATES, 1950-1962
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 5,845,834 998 1951 7,567,804 1,055 1952 7,850,083 1,035 1953 7,863,354 936 1954 8,728,941 992 1955 7,825,149 1,059 1956 9,643,336 1,183 1957 10,988,009 1,212 1958 10,053,969 1,063 1959 7,966,505 1,168 1960 9,486,919 1,349 1961 9,839,551 1,411 1962 10,479,691 1,479
Source: These figures were derived from the January and July issues of the Investment Dealers ' Digest, 1950-1963. 22
TABLE 2
TOTAL PUBLIC OFFERINGS OF:INDUSTRIAL DEBT SECURITIES, UNITED STATES, 1950-1962
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 169,879 41 1951 423,317 70 1952 1,336,521 96 1953 1,559,675 80 1954 924,465 70 1955 1,708,717 118 1956 1,933,957 138 • 1957 1,976,498 128 1958 2,508,382 113 1959 1,157,577 143 1960 1,841,824 187 1961 2,351,866 184 1962 1,089,849 144
Source: These figures were derived from the January and July issues of the Investment Dealers' Digest, 1950-1963. 23
TABLE 3
TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF SUBORDINATED DEBT SECURITIES, UNITED STATES, 1950-1962
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 14,035 11 1951 20,395 6 1952 184,588 17 1953 355,785 27 1954 129,234 23 1955 571,713' 85 1956 625,430 95 1957 939,685 105 1958 411,562 72 1959 816,141 156 1960 1,249,038 198 1961 1,136,317 281 1962 804,000 288
Source: These figures were derived from the January and July Issues of the Investment Dealers' Digest, 1950-1963. 24
TABLE 4
TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF CONVERTIBLE DEBT SECURITIES, UNITED STATES, 1950-1962 (Excluding American Telephone and Telegraph Company)
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 11,220 6 1951 67,113 22 1952 481,495 45 1953 406,756 40 1954 183,327 43 1955 819,475 88 1956 999,760 103 1957 1,038,654 96 i958 485,972 78 1959 641,809 114 1960 875,133 132 1961 785,199 179 1962 454,367 138
Source: These figures were derived from the January and July issues of the Investment Dealers' Digest, . 1950-1963. TABLE 5
TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF CONVERTIBLE SUBORDINATED DEBT SECURITIES, UNITED STATES, 1950-1962
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 1,800 2 1951 16,070 3 1952 172,776 9 1953 303,025 13 1954 31,834 U 1955 436,318 46 1956 532,889 56 1957 740,227 58 1958 274,113 46 1959 490,654 84 1960 805,702 110 1961 648,780 134 1962 360,485 113
Source: These figures were derived from the January and July issues of the Investment Dealers1 Digest, 1950-1963. TABLE 6
TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF INDUSTRIAL CONVERTIBLE SUBORDINATED DEBT SECURITIES, UNITED STATES, 195Q-1962
Year Total Dollar Amount Number of Issues (in thousands)
1950 $ 1,800 2 1951 16,070 3 1952 172,776 9 1953 303,025 13 1954 31,834 11 1955 415,135 42 1956 511,789 50 1957 705,756 52 .1958 259,613 44 1959 392,961 72 1960 729,157 95 1961 - 571,948 108 1962 326,504 100
Source: These figures were derived from the January and July issues of the Investment Dealers' Digest, 1950-1963. 27
Table 1 illustrates public offerings and private placements of debt securities. Between 1950 and 1962 the absolute dollar amounts of debt increased approximately 80 per cent while the number of is- 2 sues rose approximately 50 per cent. Table 2 presents total indus trial debt offerings which increased from $169 million to $2.5 billion in 1958„ the highest year recorded. However, the number of issues were greatest in 1960 when 187 were sold. Table 3 illustrates sub ordinated debt offerings which increased from eleven issues of $14 million in 1950 to 288 issues of $804 million in 1962. However, the greatest dollar amount of subordinated debt, $1.2 billion, was issued in 1960. Inclusion of American Telephone and Telegraph Company is sues in the convertible debt financing statistics of Table 4 would unduly influence the data and discredit years of non-issuance. Hence, they were excluded. Nevertheless, the dollar volume and number of issues increased significantly from six issues of $11 million to 138 issues of $454 million. 1957 evidenced the highest dollar volume recorded with 96 issues valued at $1 billion. Table 5 presents pub lic offerings and private placements of convertible subordinated debentures. Issues and dollar amounts have expanded from two issues of $1.8 million to 113 issues of $360 million. 1961 was the peak year for number of issues, 134. However, total dollar amount was highest in 1960, $805 million. Since most convertible subordinated
The reader is cautioned that the data in Tables 1 through 6 fluctuate violently during the thirteen-year period. Changing eco nomic conditions favorable or unfavorable to debt financing are res ponsible for this variation. Hence, no significant conclusions are observable except that feach peak surpasses the preceding one. 28
debenture issues are sold by industrials, equivalent statements ap ply to Table 6.
Table 7 and Chart 1 depict the annual dollar volume and num ber of issues of convertible subordinated debentures as a percentage of total debt securities. Constituting an increasing percentage of
total debt, the relative importance of convertible subordinated
debentures as a debt instrument is demonstrated. Despite ■ fluctua
tions each new peak and trough are higher than the preceding. Both
dollar volume and number of issues of convertible subordinated deben
tures as a percentage of total debt issues rose from less than one
per cent to more than eight per cent in the thirteen-year period.
Annual dollar volume and number of issues of industrial con vertible subordinated debentures as a percentage of industrial debt
are illustrated in Table 8 and Chart 2. The relative importance of
convertible subordinated debentures is exemplified by the increasing percentage of dollar volume employed by industrial borrowers. Since
1955, dollar volume of borrowing via industrial convertible subordin
ated debentures has increased from 24 per cent in 1955 to a peak of
39 per cent in 1960 falling to 29 per cent of total industrial borrow
ing in 1962. Issues of industrial convertible subordinated debentures
as a percentage of total industrial debt are more meaningful than
dollar amounts because of smaller fluctuations. Since 1955 the num
ber of industrial convertible subordinated debenture issues have
risen slowly but continuously until they comprised 69 per cent of the
total number, of industrial issues in 1962. 29
TABLE 7
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF CONVERTIBLE SUBORDINATED DEBT SECURITIES AS A PERCENTAGE OF TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF DEBT SECURITIES, UNITED STATES, 1950-1962
Year Dollar volume of Convertible Issues of Convertible Subor Subordinated Debt as a per dinated Debt as a percentage centage of total debt of total debt issues
1950 0.03 0.20 1951 0.21 0.28 1952 2.20 0.87 1953 3.85 1.39 1954 0.36 1.11 1955 5.58 4.34 1956 5.53 4.73 1957 6.74 4.79 1958 2.73 4.33 1959 6.16 7.19 1960 " 8.49 8.15 1961 6.59 9.50 1962 3.44 7.64
Source: Tables 1 and 5. 30
CHART 1
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF CONVERTIBLE SUBORDINATED DEBT SECURITIES AS A PERCENTAGE OF , TOTAL PUBLIC OFFERINGS AND PRIVATE PLACEMENTS OF DEBT SECURITIES, UNITED STATES, 1950-1962
Per cent Per cent
10
9
8
7
6
5 Dollar Volume-—* r ' 4
3 Issues^
2
1
0
1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962
Source: Table 7. 31
TABLE 8
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF INDUSTRIAL CONVERTIBLE SUBORDINATED DEBT SECURITIES AS A PERCENTAGE OF INDUSTRIAL DEBT SECURITIES, UNITED STATES, 1950-1962
Year Dollar volume of Industrial Issues of Industrial Conver Convertible Subordinated Debt tible Subordinated Debt as a as a percentage of industrial percentage of industrial debt debt issues
1950 1.06 4.88 1951 3.79 4.29 1952 12.93 9.38 1953 19.43 16.25 1954 3.44 15.71 1955 24.30 35.59 1956 26.46 36.23 1957 35.71 40.63 1958 10.35 38.94 1959 33.95 50.35 1960 39.59 50.80 1961 24.32 58.70 1962 29.96 69.44
Source: Tables 2 and 6. 32
CHART 2
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF INDUSTRIAL CONVERTIBLE SUBORDINATED DEBT SECURITIES AS A PERCENTAGE OF INDUSTRIAL DEBT SECURITIES, UNITED STATES, 1950-1962
Per cent Per cent
100 100
90
80 80
70
60
50 Issues' 50
40 40
30
20
10 Dollar Volume'
0
1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962
Source: Table 8. 33
Table 9 and Chart 3 depict the annual dollar volume and num ber of issues ..of convertible subordinated debentures as a percentage
of convertible debt securities, excluding the issues of The American
Telephone and Telegraph Company. Since 1955 both dollar volume and
number of issues of convertible subordinated debentures as a percen
tage of convertible debt have exceeded 50 per cent. The convertible
security with the subordination feature attached has become the pre
dominant type of convertible debt security. Convertible subordinated
debentures as a percentage of convertible debt has risen from less
than 20 per cent of dollar volume and number of issues to more than
80 per cent since 1950.
The impact of industrial convertible subordinated debentures
as a modern financing vehicle is an undeniable fact. Convertible
subordinated debentures have lately been recognized as a significant 3 media for raising debt capital in industrial firms. It has achieved
considerable status and respect among institutional, investors and
within the capital structure of industrial borrowers. However, the
accompanying risk of cash insolvency has not decreased with wide
spread employment of convertible.subordinated debentures. Rather,
it has become more acute. Therefore, a technique designed to meas
ure borrower risk-of-debt is in need of development.
0 3 A similar finding was reported by Keith L. Broman, "The Use of Convertible Subordinated Debentures by Industrial Firms, 1949-1959," The Quarterly Review of Economics and Business, III (Spring, 1963), pp. 65-75. 34
TABLE 9
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF CONVERTIBLE SUBORDINATED DEBT SECURITIES-AS A PERCENTAGE OF CONVERTIBLE DEBT SECURITIES, UNITED STATES, 1950-1962 (Excluding American Telephone and Telegraph Company)
Year Dollar volume of Convertible Issues of Convertible Sub Subordinated Debentures as a ordinated Debentures as a percentage of convertible percentage of convertible debt debt issues
1950 16.04 33.33 1951 23.94 13.64 1952 35.88 20.00 1953 74.50 32.50 1954 • 17.36 25.58 1955 53.24 52.27 1956 53.30 54.37 1957 71.27 60.42 1958 56.41 58.97 1959 76.45 73.68 1960 92.07 83.33 1961 82.63 74.86 1962 79.34 '81.88
Source: Tables 4 and 5 35
CHART 3
ANNUAL DOLLAR VOLUME AND NUMBER OF ISSUES OF CONVERTIBLE SUBORDINATED DEBT SECURITIES AS A PERCENTAGE OF CONVERTIBLE DEBT SECURITIES, UNITED STATES, 1950-1962
Per cent Per cent
100 100
90 90 Dollar Volume 80 80
70 70 Issues' 60 60
50 50
40 40
30 30
20 20
10 10
0 0
1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962
Source: Table 9. CHAPTER III
MANAGEMENT'S EXAMINATION OF ALTERNATIVE SECURITY ISSUES
This chapter is concerned with a description and evaluation of managerial methods for selecting alternative sources of funds.
The alternatives examined are common stock, internal financing, pre ferred stock and convertible subordinated debentures.
Few financial managers interviewed were prepared to comment on a subject as broad as the choices among alternative sources of funds. Direct questions on matters of over-all policy usually elic ited a response too general to be of value, whereas questions con cerning specific aspects of finance, particularly within a framework of specific decisions, brought sharp emphatic answers. Hence such general observations as seemed worthy of reporting were drawn from the record of action or from the criteria for earnings performance of new investment opportunities. Thus, as the discussion turned to the specific aspects of financing, the evidence became more pronounced.
Managerial Evaluation Criteria
Before appraising the alternative sources of funds it is nec essary to examine the evaluation criteria employed by financial mana gers. In the appraisal of alternative sources of funds financial managers employ four quantitative measures of performance referred to
36 37 as "Stock market decision criteria." The four quantitative criteria utilized by all seventeen financial managers are earnings per share, cash dividends per share, market price and price earnings ratio. ^
In order to qualify for employment in the capital structure any source of funds must favorably improvei as a minimum, two of these four market criteria.
Three reasons are advanced for the choice of these market criteria in the selection among alternative security issues. First, stockholders and security analysts are preoccupied with them. In formation is communicated regularly via security analysts seeking interviews with top company officials. Although confidential mater ial generally remained unpublicized, these interviews enabled man- 2 agement to. discover the interests of the sophisticated investor.
In addition, widespread use of executive stock option plans for senior officers has initiated an evaluation of each decision in 3 terms of its short-run impact on the market price of common. ' Self interest is undoubtedly a persuasive consideration when it coincides with the best interests of the shareholders.
Finally, financial managers measure their success on the basis of these criteria. If the absolute values of these market criteria
■'"A similar finding was reported by Gordon Donaldson, "Financial Goals: Management vs. Stockholders," Harvard Business Review, XLI (May, 1963), p. 121.
2Ibid. 3 Charles F. Poston, Restricted Stock Options for Management (Chapel Hill, North Carolina: School of Business Administration, University of North Carolina, 1960), pp. 60-61. 38 are maintained, management considers itself to have fulfilled its
responsibilities to common shareholders.
Common Stock
Managerial consideration of a potential new issue of common
stock for cash consists of measuring the effect of new outstanding
shares on the four market criteria. If an analysis indicates that
the absolute values of these market criteria will be at least main
tained, management may favorably consider an issue of common stock.
Except for stock dividends and splits, however, management refrains
from any voluntary action reducing these values. This is because
the issuance of new common for cash threatens the current performance
of these management criteria since a lag in the generation of earn
ings often prevails. This accounts for the managerial reluctance to
issue common stock. In the fifteen year period preceding 1962., the
seventeen companies in the sample issued common stock for cash only
nine times.
On the other hand, management justification of frequent issu
ance of common stock in asset acquisitions is understandable. Usual
ly, total earnings are immediately increased and the stock is with
held from trading on an organized stock exchange. Moreover, the
exchange of assets for stock is favored by management because it is
exempt from taxation if executed under the "tax-free reorganization"
provisions of the law. In such cases no income or loss is reported 39 at the time of the asset acquisition, but a capital gain or loss is • 4 absorbed upon sale of the shares.
Extreme preoccupation with current earnings per share and market price is demonstrated by widespread and persistent reluctance on the part of management to issue new common for cash. Interview evidence suggested that the financial officer was concerned with avoiding common stock dilution of earnings. Though few companies would dismiss a direct sale of common, the majority did not nor do not presently anticipate an issuance.
Internal Financing
Internal financing (conventional earnings plus depreciation and depletion allowances and other non-cash charges minus the custom ary cash dividend) furnishes funds over which the financial manager has complete and independent control. Management favored internal financing because discussions with outsiders and regulatory agencies are avoided with this type of financing. Internal financing es capes publicity and shareholder attention. Further, no new securi ties are outstanding on which interest or dividends must be paid.
However, internal financing is uncertain in amount and timing, and, as such, cannot adequately meet sudden sharp fund requirements in
times of unusual need.
Elvin F. Donaldson, Corporate Finance (New York: The Ronald Press Company, 1957), p. 686. 40
In all companies interviewed, internally generated funds were the primary source of investment funds; recourse to external sources
followed if internal generation proved insufficient.^ For example, replacement or expansion of plant facilities, vdrich required expendi
tures in excess of internal generation, caused a temporary dollar deficiency in internally generated funds.
Financial managers evaluate internally generated funds from
the point of view of the market criteria previously mentioned. As
long as reinvested internally generated funds incrementally increase
future total earnings, earnings per share increase, regardless of
the rate of return on the funds employed. The simple market cri
teria of an earnings per share standard implies to management that
internally generated funds are cost-free.^ Most financial officers
in the sample argued that internal financing failed to increase
operating costs as do bonds or add to cash outlays as do dividend- bearing stocks. In view of managerial reliance on internal financing,
recognition of the inadequacy of the earnings per share standard is
of utmost importance.
A simplified example may be helpful. Assume the following
facts about an imaginary company:
(1) Current net earnings after taxes--$l,000,000 per year
A similar finding was:reported by Gordon Donaldson, Corporate Debt Capacity (Boston, Mass.: Graduate School of Business Adminis tration, Harvard University, 1961), p. 44.
^Ibid. , p. 60T 41
(2) Only common stock outstanding, 1,000,000 shares currently
selling on the market at $15 a share
(3) Dividend payout--40 per cent
(4) Resultant earnings per share--$1.00
Dividend per share--$0.40
Retained earnings--$600,000
(5) Noncash charges--$300,000
(6) Funds required for investment in coming year--$900,000
Assuming that the company has a continued internal generation of
$900,000 in the coming year and that its requirements are such that
they can be timed to match internal generation, this company can
avoid the necessity of going outside for funds. Whatever is earned
on the $900,000 reinvested will add something to the current net
earnings of $1,000,000 and earnings per share will increase. If,
for example, it is only 2 per cent after taxes, the new net earnings
will be $1,000,000 + yfo (900,000) = $1,018,000 or $1.02 a share.
Suppose alternatively that the company had to raise $900,000
by the sale of common stock and that it could be sold at the current
market price of $15 a share (a favorable assumption). This would add
60,000 new shares. In order to earn the same earnings per share as
before, the new level of earnings would have to be $1,060,000. This
would mean an incremental return of approximately 6.6 per cert on the
$900,000 investment to maintain earnings per share of $1.00. Obvious
ly, if management performance is to be measured by the amount of the 42 increase in earnings and dividends per share (and in market price which reflects these), the goal of managerial success is much, more easily attained if equity capital is supplied by the internal finan cing route.
The following comparison may help to clarify the above example:
Before considering If internal If common fund requirements funds employed stock employed
Funds required $900,000 $900,000 Shares outstanding 1,000,000 1,000,000 1,060,000 Approximate rate of return on new funds employed 6 . 6% 6.6% Earnings after taxes $1,000,000 $1,060,000 $1,060,000 Earnings per share $1.00 $1.06 $1.00
/
Dividend Policy
One important aspect of internal financing is the cash divi dend policy pursued by any company. Periodic examination of the div idend payout proportions in light of expected rate of return and internal investment opportunities was not conducted by managements of the sample companies.^ Regardless of considerable variation in payout percentages, departure from traditional company practice was deemed inappropriate. Invariably, financial managers argued that, for tax reasons, shareholders preferred future capital gains to additional current dividend income. However, statistically valid
/A similar finding was reported by James E. Walter, "Dividend Policies and Common Stock Prices," The Journal of Finance, XI (March, 1956), pp. 29-41. 43 information of the circumstances and wishes of shareholders was lack-
* ing. It was argued that shareholders, desirous of a stable current 8 income, were satisfied by the present dividend.
When internally generated funds exceeded current needs, the treasurer subrogated a reappraisal of payout in dividends or sinking fund payments to a search for new investment opportunities. The fol lowing reasons for 6uch a policy were advanced by the treasurers of the sample companies: cash dividends were easily increased but re ductions met with vigorous resistance. Inability to foresee future needs caused the cautious financial officer to preserve maximum flex ibility. Further, a surplus of cash challenged the aggressiveness of management, encouraged stockholder clamoring for increased divi dends and invited raiders.
Preferred Stock
9 While utilizing the four quantitative market standards, more favorable to the use of internally generated funds than the sale of common stock, management attempted to avoid reliance on common when heeds exceeded internal generation. This led to an examination of preferred stock. In theory, preferred stock offers a means of avoid ing the dilution of common. It also avoids the fixed obligations of
8 A similar finding was reported by G. Clark Thompson and Francis J. Walsh, Jr., "Companies Stress Dividend Consistency," Management Record, XXV (January, 1963), pp. 30-36. 9 See page 36. 44 debt. However, it was not a popular alternative among the companies in the sample.^ Preferred stock, both straight and convertible, was employed as a supplement to debt by only seven of the seventeen companies studied.
Three of these experienced fund requirements in excess of internal generation and employed both straight and convertible pre ferred. Convertible preferred was considered by management a future issue of common in excess of its present worth.^ Such stock added to the equity base and avoided immediate dilution. Moreover, all three financial managers stated that the issuance of new common was postponed until the new investment was able to achieve earning power and the market experienced a strong upward trend.
Seven companies had an issue of straight preferred outstanding at some time during the fifteen-year period. That the majority at tempted to eliminate it is an indication of its relative unpopularity.
Although preferred stock legally is ownership capital, management re garded it as "outsider" capital. Restrictive covenants and voting rights accompanying the issuance of preferred stock were considered as interference. Since management felt a responsibility to. pay a regular common dividend, the preferred dividend was considered as mandatory as debt servicing.
similar finding was reported by Leonard Jay Santow, "Ul timate Demise of Preferred Stock as a Source of Corporate Capital," The Financial Analysts Journal. XVIII (May, 1962), p. 48.
^Ibid. , pp. 53-54. 45
Preferred suffers in comparison to a bond issue with its lower interest charges which are also tax deductible. For this reason, management endeavored to eliminate the preferred. Some companies in the sample decreased preferred through a redemption fund and/or open-market purchases. Others exchanged it for bonds or issued bonds for cash and retired the preferred with the proceeds. These pro- 12 cedures are referred to as preferred stock recapitalization. In summary, preferred stock was not favored as a method of financing by the financial managers of the sample companies.
The Incentive to Borrow
Every financial officer was aware of the reputed advantage of debt leverage. Moreover, each officer stressed the advantage of in come tax deductibility of interest payments as opposed to the non-tax deductibility of dividends on stock. However, some businessmen did not fully exploit the income possibilities of debt until the period of.high tax rates during and following World War II. Awareness of the advantage of a tax shield on interest payments provided the pri mary motivation for preferred stock recapitalization. For the majority, the income advantage of debt was assumed to remain fixed at any level which management and creditors were prepared to consider.
No evidence of an effort to employ a "break-even" analysis among
12 Elvin F. Donaldson and John K. Pfahl, Corporate Finance (2nd ed.; New York: The Ronald Press Company, 1963), p. 279. 46 alternative sources of funds was discovered. Consequently, precise cost comparisons among financing alternatives prior to a decision on 13 external financing were not developed. For a minority, earnings per share comparisons were based on varying sales assumptions. How ever, the motive was the preparation of a report for the board of directors rather than a quantitative evaluation of alternative se curity issues. A tendency to base decisions on abiding convictions rather than on precise analysis was prevalent except for businesses considering an initial public offering of debt.
/
Borrowing Versus Internal Financing
Motivated by an earnings per share comparison, businesses in variably employ internally generated funds prior to debt or outside 14 equity sources. Therefore, an order of priority for the employ ment of funds is established by utilization of the four stock market criteria. The order of priority becomes internally generated funds, debt, common stock, and preferred stock.^
13 A similar finding was reported by Joe S. Floyd and Luther H. Hodges, Jr., Financing Industrial Growth: Private and Public Sources of Long Term Capital for Industry (Chapel Hill, North Carol ina: School of Business Administration, University of North Carolina, 1962), pp. 37-39. 14 A similar finding was reported by George Heberton Evans, Jr., "Discussion: The Development of Historical Series on Sources and Uses of Corporate Funds," Conference on Research in Business Finance (New York: National Bureau of Economic Research, Inc., 1952), p. 23.
^Gordon Donaldson has stated the order of priority as inter nally generated funds, debt, preferred stock and common stock in a recent article entitled "In Defense of Preferred Stock," Harvard Business Review, XL (July, 1962), p. 132. 47
The view is widely expressed among financial managers that utilization of internally generated funds to the point of decreasing
the accustomed dividend per share, would have an adverse impact on
the market price of the common stock. On an incremental basis,
charging the expected loss in market price against the funds made
available by a reduction in the customary cash dividend rather than
against all retained earnings makes the cost prohibitive. Such a
dividend reduction is unthinkable to management except as a defen-
sive measure m times of* financial , stress. 16
Borrowing Versus Common Stock Financing
Recognizing the priority given by financial management to
internal financing, external financing is considered only when in
ternally generated funds are inadequate to meet the existing need.
If such is the case, a decision between debt and stock is required.
With performance judged in terms of market price and earnings per
share, the disadvantages of financing by increasing the number of
common shares are apparent to the financial manager.^ Employing
debt relieves the current market of a direct threat of dilution re
sulting from the additional shares. Even after a cash flow compari
son and the allowance for sinking fund payments, debt is desirable
^Thompson and Walsh, loc. cit., pp. 35-36.
^G. Donaldson, loc. cit. , p. 135. 48 since management would have to provide cash dividends on new common.
Such a payment, lacking a tax shield, is at a higher rate per dollar of invested funds.
Timing and Flexibility of Debt
The limited duration of the contract and the relative ease of its termination are often quoted managerial incentives to the employment of temporary debt. Assuming that internally generated capital is the best, i.e., cheapest, source of funds for permanent use and that management discovers a temporary uncontrollable peakinjg, then a managerial incentive exists to finance from repayable rather than permanent sources. Accordingly, debt has a distinct advantage over common equity. Stock can be repurchased and retired, but the process is often uncertain and difficult; debt retirement is con templated at issuance. In several companies the use of debt was considered the present means of employing future retained earnings.
Any company which accepts these premises has distinctly lim- 18 ited its investment goals. However, the selection of a contract basis which best achieves this managerial objective is logically sound.
The conventional cash forecast employed by companies in the sample is the result of a combination of elements differing in
18 A similar finding was reported by J. Fred Weston, "The Timing of Financial Policy," The Controller. XXIX (December, 1961), pp. 596-600. 49 certainty of amount and timing as well as controllability. For the outflows controlled by management, a distinction is required between those considered mandatory and/or discretionary. The degree to which controllable outflows are mandatory or discretionary obviously affects the extent of pressure for added investment capital. In order to better understand the problem of attempting to "time” out flows, consider the expenditure by companies in the sample for plant and equipment.
Timing of capital expenditures is subject to a variety of ex ternal influences including the company's competitive situation, technological obsolescence, deterioration of physical assets and variations in consumer demand. A combination of events may produce irregular peaks in capital needs which substantially exceed internal 19 resources. The employment of outside funds among companies in the sample results from an uncontrollable peaking of mandatory expendi tures rather than from a discretionary investment choice. As such, debt capital best satisfies the needs of financial managers of the companies in the sample regarding timing and flexibility.
Inflation
Although inflation is often cited as an incentive to finance 20 on the basis of fixed dollar commitments, only a minority of the I
19Ibid., p. 600. 20 Neil H. Jacoby and J. Fred Weston, "Factors Influencing Man agerial Decisions in Determining Forms of Business Financing: An Exploratory Study," Conference on Research in Business Finance, (New York: National Bureau of Economic Research, 1952), pp. 167-169. 50 companies studied employed debt for this reason. However, alien subsidiaries with serious inflationary problems were borrowing pro fusely. Apparently, this did not influence the debt policy of the parent company because such subsidiaries accounted for only a small fraction of the total commitment of funds.
Psychological Factors
Undoubtedly, debt is one aspect of financial policy affected by the deep-seated attitudes of those making the decision. Whether an individual is conservative or venturesome is a matter of broader implications than the debt-equity choice. Yet it can be the deter mining factor. Such prejudices are rooted in the accumulation of experiences and jeopardize an intelligent appraisal of existing and future circumstances. Influential board members need not justify their viewpoints; it is sufficient that they adhere to them. Dogmat ic positions inhibit detailed logical analysis by financial officers whose task may be reduced to finding a convincing reason for an un reasoned conviction.
I Convertible Subordinated Debentures
Industrial corporations have always adapted their capital structures to the needs of the times. The debenture bond originated
21Ibid., pp. 170-172. 51 shortly after the Civil War but did not acquire prominence until 1900 when indentures were first executed for the protection of bondhold- era. 22 Debentures have increased in importance due to the "prejudice among bankers and stockholders against directly mortgaging a manu- 23 facturing plant." With added usage and changing corporate needs, debentures have assumed diverse forms, e.g., assumed bonds, guaran teed bonds, and joint bonds. Moreover, numerous speculative features have appeared during periods of rising interest rates and unsettled equity market conditions. These include convertibility, redemption, warrants, and subordination.
This section is concerned with the primary considerations in a managerial decision to issue convertible subordinated debentures.
Managerial attitudes toward convertibility and subordination will be simultaneously considered. The areas of primary concern to finan cial managers of the sample companies were: (1) fluctuations in the market price of common stock, (2) cost of debt versus equity capital,
(3) flotation cost of securities, (4) marketability of large blocks of securities, and (5) the borrowing base.
22 Charles W. Gerstenberg, Financial Organization and Manage ment of Business (4th ed.; Englewood Cliffs, New Jersey: Prentice- Hall, Inc., 1959), p. 132. 23 Arthur Stone Dewing, The Financial Policies of Corporations (2 Vols.; 5th ed.; New York: The Ronald Press Company, 1953), p. 227. 52
Market Price Considerations
Management viewed the sale of convertible subordinated deben tures as a means of issuing common stock at a price per share above current market quotations. For example, if the current market price of the common was $20 per share, the sale, at its face value, of a
$1,000 convertible subordinated debenture, convertible at $25, would, if and when converted, effect the sale of common at $25 per share.
The corporation obtained $1,000 from the sale of the bond which ul timately may be surrendered in exchange for 40 shares of new common stock. The sale of the 40 shares at the market price of $20, at the time the convertible subordinated debentures were offered, would have netted the issuer only $800.
Some security analysts believe that the value of common stock is dependent upon future earnings and the risk attached to their 24 realization. However, all financial managers recognize that cer tain investors are influenced by past years' earnings, particularly those most recent. These are regarded as real results while future earnings are difficult to predict. If investors are relying heavily on past earnings performance, some financial managers thought prob able future growth in earnings might be inadequately valued by the market.
24 Douglas H. Bellemore, Investment Principles, Practices and Analysis (2nd ed.; New York: Simmons-Boardman Publishing Corp., 1960), p . 468. 53
The following correspondence is indicative of management's reaction to valuation of common stock. The vice-president and treas urer of a petroleum refining company remarked:
Because we believed that the common stock of our corporation was undervalued, we elected to sell a conver tible subordinated debenture issue carrying conversion privileges above the current market for the stock. This resulted in the ultimate sale of common equity at a higher price than would have been possible otherwise.
This method of issuing common stock necessitates the addition of fewer new shares than required if the same amount of capital was secured thrbugh a direct offering at the current market price. There fore, the issuance of convertible subordinated debentures would be advantageous if above-average prospects for additional earnings and 25 an increase in stock prices are present. Because of the then cur rent depression of the market price for common stock the opportunity exists for selling common stock on more favorable terms via a con vertible subordinated debenture issue. Any temporary overemphasis on current earnings and dividends leaves financial managers reluc tant to sell new common for cash.
When new common is offered to existing stockholders on a priv ileged subscription basis, underpricing is necessary to allow for normal market fluctuations and to compensate for the pressure of new 26 stock. Subscriptions will not occur as long as the subscription
A similar finding was reported by John F. Childs, "Conver tible Debentures as a Medium of Financing," Public Utilities Fort nightly. XLI (March 1, 1948), pp. 333-343. 26 Harry G. Guthmann and Herbert E. Dougall, Corporate Finan cial Policy (4th ed.; Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1962), pp. 416-417. 54 price is above that of the market. Underpricing further decreases the per share offering price when comparing direct issue to the is- 27 sue of common by means of a convertible. An officer of an aero space company wrote:
Had our corporation decided to issue additional shares of common stock, it would have been necessary to sell such shares for $35 representing a reduction of $7 in relation to the existing market price of $42 per share. As an alternative, we issued con vertible subordinated debentures initially convertible at $3 per share above current common quotations. We , . were attempting to raise common capital at $45 per * share rather than $35.
The following example may help to clarify the above statement:
If direct sale employed If convertible employed
market price $42 conversion price $45 subscription price 35 market price 42 reduction below ‘ increase above market price $ 7 market price $ 3
Therefore, the difference between the conversion price $45 and the subscription price $35 represents $10 which is the excess amount re ceived by employing the convertible debenture as opposed to a direct sale of common stock.
Consider the attitude of financial managers in the sample regarding a common stock dividend policy and the impact of issuing fewer shares on that dividend policy. Assume a company is pursuing a stable per share dividend policy. While such payments are legally voluntary, a strong obligation exists to continue the traditional
27 C. James Pilcher, Raising Capital with Convertible Securi ties (Ann Arbor, Michigan: Bureau of Business Research, School of Business, University of Michigan, 1955), pp. 77-78. 55 dividend per share on new stock issued. If a small amount per share is received, a larger number of shares must be sold to raise a speci fied sum. Therefore, total dollar dividend distributions are in creased. This is because outstanding shares, multiplied by the dividend per share, determine the aggregate dividend requirement.
The underpricing of new common results in the issuance of additional shares with a greater aggregate dividend obligation than if offered at or above the current market price. On the other hand, the sale of convertible subordinated debentures with the conversion price above the current market price, when converted, would require the issuance of fewer shares than if an equivalent amount of capital had been acquired via the direct sale of common. With fewer shares out standing, any per share dividend payment would necessitate fewer funds. In such a situation, a convertible subordinated debenture is considered by the financial managers of companies in the sample.
In addition to the problem of dividend distribution, the is suance of a significant amount of new common stock may depress the price of outstanding common. Absorption, by the capital markets, of a sizeable batch of new common in the short period allotted to its sale may depress the price of outstanding shares. A temporary over supply may result from inability of the capital markets to absorb 28 the additional shares offered. A financial manager, aware of this possibility in determining the subscription price, may include some
28 ' Guthmann and Dougall, loc. cit., pp. 421-422. 56 buffer to compensate for market fluctuations and market pressure.
In such circumstances, the issuance of a security, convertible at or above the current market price, substitutes for the direct sale 29 of common at too low a price per share. When the subordinated issue is converted, the resulting shares appear over an extended * period. Company evidence indicates that convertible subordinated debenture issues, which make immediate conversion attractive, are 30 gradually exchanged for common. In effect, the issuer agrees to accept stock subscriptions for a number of years.
Capital and Flotation Cost Considerations
Management's desire to obtain a better price for common than that possible by direct issuance is not the only managerial reason for the sale of a convertible contract. A common reason advanced by financial managers is that the issuer immediately requires funds for expansion but cannot afford the cost of common capital until the in vested funds begin to generate earnings. During the construction period all owners would share equally in earnings and dividends. In addition, such dividend requirements would increase before funds 31 generated by new earnings become available.
' 29 Pilcher, loc. cit. , p. 79. 30 A similar finding was reported by Pilcher, p. 80. 31 A similar finding was reported by Pilcher, p. 83. 57
Hence, a delayed method of raising common capital by the of fering of convertible subordinated debentures has definite company advantages. The interest rate on convertible subordinated debentures is lower than the rate of dividends on a common or preferred stock issue. Moreover, bond interest is deductible for income taxes, where as dividends are not. Once the capital has been productively em ployed and additional earnings in excess of the rate paid on the debentures are anticipated, stock prices should increase and conver sion is likely. Thus, new common shares will be outstanding when earnings will support them. Assuming taxable profits exist, conver tible subordinated debentures provide an economical means of tempor arily financing new construction. When earnings are forthcoming, conversion may eliminate fixed charges and principal repayment.
Procurement of residual equity funds via an issue of conver tible subordinated debentures is economical because charges of in vestment bankers for underwriting bond issues are less than for com mon stock. Underwriters' commissions and discounts for nearly
$33 billion of securities, registered under the Securities Act of
1933 during the six-year period 1950-1955, amounted to $1.49 per
$100 of securities sold for bonds, $4.34 for preferred stocks and 32 $10.28 for common.
While many managerial motives influence the decision to issue
convertible subordinated debentures, any listing of reasons always
U. S., Securities and Exchange Commission, Cost of Flota tion of Corporate Securities, 1951-1955, (1957), p. 37. 58 / included the following: the desire to enhance the marketability of a security weak in some aspect of the contract and the desire to broaden the borrowing base. These topics will now be considered.
Enhancing Marketability
An offering of convertible subordinated debentures attracts institutional investors into the interested purchaser group which results in a broader capital market for the desired funds. The institutional investors are attracted because the majority are pro hibited or limited, by law or tradition, from purchasing stock.
Hence, they view this as one method of compensating for inflation and attempting to secure a long-term capital gain. Moreover, in stitutional investors recognize that the higher the price of the stock, the greater will be the rise in the price of the convertible
33 subordinated debenture. Every financial manager interviewed was aware of the above facts and indicated they were considered in a decision to sell convertible subordinated debentures.
Consider the point of view of the institutional investor regarding inflation. All investors interviewed stated that conver tible subordinated debentures may function as a hedge against infla tion. Certain common stocks in the sample provide considerable pro tection against a depreciating dollar. Rising commodity prices tend
C. James Pilcher, "Convertibles--Senior Securities or Com mon," Michigan Business Review, X (January, 1958), pp. 22-25. 59 to increase the value of physical properties, e.g., natural resources.
Revenues generated from such properties increase earnings of common stock to compensate for the loss in purchasing power per dollar of profits. A security with a call on common may benefit from an in crease in earnings whereas a straight bond would not.
Confronted with a contract lacking sufficient marketability., some financial managers resorted to convertibility because it is 34 fashionable. Thus, it became expedient to include such a provision in an issue of subordinated debt. Preference for a conversion priv ilege need not be based on rigorous managerial reasoning. The treasurer of a chemical company interpreted his corporation's action as follows:
At the time of our original offering of convertible subordinated debentures, the market was such that a straight subordinated debenture might not be readily acceptable. Therefore, it was decided to include the convertible feature, at the request of the underwriter, to make the ' subordinated debenture more attractive and to carry a lower coupon rate.
All financial managers in the sample believe the attachment of a conversion option permits the issuer to relax other provisions of the contract. Assuming any new debt contracts must be subordinated, a conversion privilege may substitute for a prohibitively high
34A similar finding was reported by Pilcher, p. 85. coupon rate and neutralize the subordination provision. It is not
inferred that a conversion option causes the investor to relax in
sistence upon the protective provisions of a nonconvertible. The presence of the convertible privilege, however, may cause investors . • 36 to place less emphasis on repayment or maturity provisions.
Borrowing Base Considerations
Subordinated debt, originally designed by finance companies, permitted the expansion of bank credit followed by additional loans
to consumers. Such a security enabled the company to tap the long
term capital market and to enhance its ability to borrow additional
short-term funds. Subordinated debt was essential if expansion of
loans, after borrowing the maximum available on a senior and short
term basis, was to continue. Issuers were further motivated because
subordinated debt possessed the dual advantage of tax deductibility of interest payments and avoidance of equity over-capitalization in 37 a period of declining loans.
Subordinated debentures broaden the borrowing base without
the issuance of common or preferred stock. Prior to the use of
35 A similar finding was reported by Stanley R. Miller, "In creased Usage of Convertible and Subordinated Issues," The Commer cial and Financial Chronicle, CXXVI (November 20, 1952), p. 3. 36 Repayment and maturity provisions will be discussed in Chapter V. 37 Robert W. Johnson, "Subordinated Debentures: Debt That Serves as Equity," The Journal of Finance, X (March, 1955), pp. 1-5. 61 subordinated debt, the customary indenture provision limited debt to a fixed ratio of stockholders' equity to long-term debt, commonly
2:1 or 3:1. However, when subordinated debt was recognized as a component of the borrowing base, the base was computed as stock holders' equity plus subordinated debt. Thus, further borrowing be came permissible without an issue of stock to correct the required debt to equity relationship. Recently, finance companies reaching the customary contractual limit of subordinated debt authorized in the indenture (usually 50 per cent of stockholders' equity), began to issue junior subordinated debentures (maximum usually 40 per cent 38 of stockholders' equity). The following example illustrates the use and implications of subordinated and junior subordinated debt.
Example 1 illustrates the computation and implications of broadening the borrowing base under three distinct situations. The first situation illustrates a capital structure without subordinated or junior subordinated debentures. In this case, the ratio of total maximum borrowing is two times that of stockholders' equity. In the second situation, subordinated debentures are introduced as a part of the borrowing base and the ratio of total maximum borrowing be comes 3.5 times that of stockholders' equity. In the third situation, both subordinated and junior subordinated debentures are employed in
the capital structure with the result that the ratio of total maxi mum borrowing is 6.3 times that of the stockholders' equity. In
/ EXAMPLE 1
BROADENING THE BORROWING BASE BY EMPLOYING SUBORDINATED DEBT AND JUNIOR SUBORDINATED DEBT (Assuming a 2 to 1 ratio of senior debt to the borrowing base)
Without Subordinated With Subordinated With Subordinated or Junior but without Debt and Junior Subordinated Debt Junior Subordinated Subordinated Debt
Stockholders' Equity $10,000,000 $10,000,000 $10,000,000
Subordinated 0 5,000,000 7,000,000
Junior Subordinated 0 0 4,000,000
Borrowing Base 10,000,000 15,000,000 21,000,000
Maximum Senior Debt 20,000,000 30,000,000 42,000,000
Total Maximum Borrowing $20,000,000 $35,000,000 $63,000,000 63
this example, a one dollar increase in subordinated or junior sub ordinated debentures permitted a two dollar increase in senior debt.
Therefore, a one dollar increase in subordinated or junior subordin ated debentures permitted a three dollar increase in total borrowing.
Subordinated debentures substitute for stock in providing protection for senior creditors. Their sale furnishes cash and per mits additional borrowing. Further, subordination of claims extends
to existing and contemplated senior debt. The sale of subordinated debentures, therefore, expands corporation assets, may result in
increases in earning power and may enable the company to attract 39 additional senior lenders. Every financial manager interviewed was aware of the above reasons for issuance and indicated they were
considered in a decision to sell convertible subordinated debentures.
Limitations on Employment
Consider the objections to subordinated debentures as related by financial officers of the companies in the sample. Interviews revealed that comparative interest costs and restrictions on the
amount of outstanding debt permitted are the principal managerial
objections to subordinated debt. While the cost of debentures is below that of stock, long- and short-term bank loans have even lower
rates. Moreover, interest coverage provisions in the indentures
examined stipulate a before-tax coverage of combined fixed interest
39 Frank J. Paul, "Analysis of the Banker's Position with Respect to Subordinated Long Term Debt," Robert Morris Associates Bulletin, XXX (May, 1948), p. 440. 64 charges of four for industrials. Finance companies and utilities enjoy lower coverage requirements because of their outstanding liquidity and earnings record. ^
The use of subordinated debentures is restricted by the sam ple company indentures which limit issuance of subordinated deben tures to a maximum of 50 per cent of stockholders' equity. However, the issuance of junior subordinated debentures may dilute the per cent of stockholders' equity to subordinated debentures if permitted by the indenture. (See Example 1.)
Summary
If the circumstances and interests of the common shareholder are fairly considered, there should be a substantial number of com panies in our sample for which convertible subordinated debentures is outranked only by internally generated funds and senior debt in priority of use. Where this is the case, financial policy should be so arranged that both senior debt and internal funds will be used as continuously as possible within the limits set by management.
Even for the company where the normal rate of growth can gen erally be sustained by senior debt plus internal funds, there are times when the need for funds temporarily exceeds these sources and a choice must be made between convertible subordinated debentures »
Johnson, loc. cit., p. 14. 65 and a new equity issue. If internal funds and nonconvertible senior securities have been used to the limit that management or investment bankers consider appropriate or further senior debt is prohibited by the bond indenture, then a broadening of the borrowing base is the remaining alternative. Under such circumstances a convertible subordinated debenture offers the prospect of the most favorable pricing of the common (when ultimately converted).
However, before actual conversion of the subordinated deben tures occurs, substantial debt servicing risk must be assumed. The problem then reduces to the question of whether the prospective gain in pricing of the common is worth the risk which the company runs by exceeding its normal debt limits when the convertible subordinated debentures are issued. Convertible subordinated debentures have been found to be more desirable than a direct issue of common or pre ferred stock and should therefore be used up to their appropriate lim it. This may mean using convertible subordinated debentures for a limited period of years, to be redeemed, if not converted, out of internally generated funds when the peak has subsided. It is for this reason that convertible subordinated debentures are usually callable. They may be expected to come and go in the capital struc ture with the ebb and flow of fund requirements over the years. CHAPTER IV
SOURCES FOR THE FORMULATION OF RISK OF BORROWING RULES IN THE COMPANIES INVESTIGATED
The purpose of this chapter is to present and evaluate the
references employed by management in the formulation of decision
standards regarding the risk of debt. In particular, this phase of
the study centers on determining whether the risk standard is con
ceived inside or outside the borrowing corporation and the reasons
for its acceptance as a risk policy.
The references may be classified as dependent and independent.
A dependent standard is formulated by considering the capital struc
ture of other companies and the standards imposed by institutional
investors. Dependent standards consider information sources external
to the company. An independent standard is one formulated from in
ternal sources of information. They are designed to meet the needs
and objectives of one particular company.
The order of presentation of this chapter is as follows: The de
pendent standards are presented then evaluated. The influence of the
capital structure of other companies on a potential borrower is con
sidered. Then the influence of the standards employed by institu
tional investors is examined. This is followed by a presentation and
analysis of the independent standards._ The information in the chap
ter Was the result of personal interviews with the financial managers
66 / 67
of the companies in the sample and the writer's evaluation thereof.
Some borrowers delegated the responsibility of risk ap
praisal to the prospective creditor because they considered them
selves incapable of risk analysis. Further, reputable investors,
being conservative lenders, were unlikely to purchase additional debt
if the only favorable factor was the borrower's evidence that such
debt could be serviced. This sense of frustration caused some bor
rowers to delegate this responsibility to institutional investors.
In constrast, other borrowers employed an operational standard of
risk-bearing capacity unrelated to the opinions or practices of
creditors.
Dependent Standards
In general, business firms rely upon two external sources for
risk standards--the practice of companies in similar industries and
recommendations of investing institutions (predominately life in
surance companies) indirectly received through financial interme
diaries (investment bankers).^
A similar finding was reported by Gordon Donaldson, "New Framework for Corporate Debt Policy," Harvard Business Review, XL (March, 1962), pp. 117-131 and Eli Schwartz, "Theory of the Capital Structure of the Firm," The Journal of Finance. XIV (March, 1959), pp. 18-39. 68
The Capital Structure of Other Companies in Similar Industries
By noting the capital structure of other companies, manage ment developed a quantitative standard of the ability of those companies to assume debt. The derived standard was then applied to the company under examination. A judgment was formulated regarding its ability or inability to assume additional debt. In the absence of other criteria, the only meaningful policy was to remain within the limits established by other companies.
Reliance on the experience of others was confined to an in formal comparison with companies in the same industry and competitors in the same market. The comparisons were limited to a calculation ■ / of current percentages of long-term debt to net tangible assets.
The appropriateness of a historical percentage comparison in formulating individual company risk policy is questionable. Whether historical characteristics are sufficiently comparable to warrant the expectation of similarity in risk in another company is doubtful. The acceptance of such evidence implies that other managements have made their decisions rationally on the basis of meaningful information and
that such policies have been proven safe and workable. Moreover, widespread managerial acceptance of a historical norm may be inconsis
tent with estimates of future risk and attitudes to risk-bearing. 69
Standards of the Institutional Investor as Communicated by Investment Bankers
The second dependent standard employed by financial managers is derived from institutional investors. Borrowing corporations adopt the risk standards of investing institutions when dependence upon these investors is total and explicit. In some cases investors' risk criteria are actively sought; in others, they are passively ac cepted as a condition for borrowing. Three examples of this follow.
An office equipment company planned an expansion of plant facilities via the flotation of additional debt. Certain members of the board of directors hesitated to increase debt beyond 30 per cent of net tangible assets. The financial vice-president was reluctant to accept this limit and sought the advice of an investment banker who considered 35 or 40 per cent as feasible. Convertible subordinated debentures were floated and total long-term debt to net tangible assets exceeded the 30 per cent limit.
A petroleum refining company was accustomed to employing debt and continuously traded on the equity to increase return on the com mon stock investment. A need for $10,000,000 initiated an examination of the effect of additional long-term debt on the balance sheet and
that of increased carrying charges on the ratio of earnings coverage.
A long-term debt to net tangible assets percentage of 31, previously
exceeded without ill effects, was considered conservative by an in
vestment banker. For several years, earnings available for debt
servicing before federal income taxes had been four to six times / '
70
total debt servicing including the proposed issue. Oh the strength of this evidence, the investment banker and the treasurer were satis fied that new debt did not involve excessive risk. * A chemical company was contemplating an issue of convertible subordinated debentures for the first time. Although the limits of its risk-bearing and debt capacity were doubtful, the company decided that the new issue lay within these limits. In discussing the pro posed indenture with the investment banker, the determination of a limit on further borrowing proved troublesome. Since one managerial objective was an "A" rating, the investment banker discussed the pro posed indenture with a bond rating agency. The issuing company was willing to accept a debt limit of 30 per cent of net tangible assets.
The investment banker, however, felt this was unnecessarily restric tive and recommended 50 per cent as a limit. Final agreement estab lished an absolute upper limit of 40 per cent; an "A" rating was ob tained.
The above examples illustrate the influence of investment bankers and bond rating agencies on the development of risk criteria.
Because both are in intimate contact with institutions supplying debt capital, some borrowers rely completely on them for an indication of acceptability by creditors.
On the other hand, not all investment bankers were willing to define the borrower's risk-bearing capacity beyond the amount cur rently outstanding or under negotiation. To do so was considered a commitment to underwrite a future debt issue. Therefore, each 71 ’ decision was based upon a formal underwriting request. Whether the particular investment banking firm met the underwriting request be came the borrower test of appropriate risk-bearing capacity.
In contrast, other investment bankers were willing to define a company's over-all debt limits. Willingness was influenced by the size, financial strength and bargaining position of the borrower, the closeness of the investment banker-lender-borrower relationship and the condition of the money market. In such cases the opinion of the investment banker was defined in the form of a future borrowing cov- 2 enant in the loan agreement. This covenant then became the risk standard for the company.
In any debt negotiation the investment banker is evaluating a specific investment and loan proposal, not formulating a borrower risk policy. Nevertheless, the Investment banker must decide whether the proposal is within the investor's current risk standard. Approval of the underwriting and loan request was interpreted by management that risk is reasonable and that the company is not expected to default on its contractual obligations.
Borrowers were unable to formulate an independent appraisal of risk based on the investment banker's decision to underwrite additional
Refer to the example of the chemical company on page 69.
4 72
debt. This is because the financial manager did not possess the same background and experience as the investment banker. Moreover, the basic purposes, functions, objectives and viewpoints of the borrower and lender were radically different. Consequently, the borrower had to accept any loan decision on his faith in the competence of the underwriters.
Investment Banker's Risk Analysis
Some investment bankers employed the borrower's income state ment, balance sheet and cash forecast in their appraisal of risk.
These conventional financial statements were used to determine the soundness of the capital structure as well as the magnitude, trend and stability of earnings. Management's cash forecast reflected the expected impact of new capital expenditures, additional capital re quirements and potential sources of funds.
The cash forecast was useful in appraising the capacity of the business to meet mandatory cash payments. Hence, the information needed to appraise the risk of cash insolvency was provided. How ever, the investment banker recognized limitations to its usefulness.
Since expansion was commonly contemplated during prosperity, the fore
cast failed to realistically account for any adverse circumstances
that might occur during that period. Thus, the borrowing corporation
gave the benefit of any doubt to itself.
The investment banker, acknowledging the limitations of time
and data available, prepared an independent approximation of cash
flow based upon an estimate of the impact of adversity on net earnings 73
available for debt servicing. This estimate was then related to
contemplated debt servicing and a judgment of its adequacy was formu
lated. Whether the investment banker was influenced by a predetermined
risk standard is, for this study, a matter of speculation. In any
case, this standard, if it existed, was not often explicit.
The usual efforts of the investment banker to predict the
1 probable limits of cash flow were too imprecise to be useful in for
mulating borrower risk policy. However, there were good reasons,
other than expediency, for the investment banker to be content with
such approximations. The borrowers were large companies, mature and
historically profitable. The amounts of debt requested and granted to
them were modest. Very few had outstanding debt in excess of 40 per
cent of net tangible assets. Moreover, investor risk standards, re
flected in loan covenants, contained built-in margins of safety. In
addition, by focusing attention on net earnings in adversity, the
investment banker ignored the potential release of funds from contrac
tion of working capital. Likewise, that portion of the inflow ob
scured by non-cash expenses, notably depreciation, was often disre
garded. Further, it was considered conservative to ignore the
potential earnings resulting from the investment of debt funds.
The adequacy of the rough approximations employed by the in
vestment banker was also supported by the investor's unsecured claim
to the business assets. While the amount of debt servicing would
remain constant throughout the life of the loan, investors expected
sinking fund payments, conversion into common stock and the accumula- 74 tion of retained earnings to improve the asset-debt ratio. This in turn improved their position.
In contrast, an institutional investor's risk standard seldom is designed to preclude insolvency among industrial borrowers. Losses by institutional investors can, in the long run, be considered an ac ceptable cost of operation. If experience demonstrates an excessively liberal standard and the cost of such defaults becomes prohibitive, the standard can be raised. However appropriate such a standard may be for the investor, it is fallacious to assume it applicable to the risk policy of an industrial borrower. This is because the investor is concerned only with contractual demands on cash which precede his.
The borrowing corporation, on the other hand, must consider capital expenditures and dividend payments as equally mandatory.
The Independent Standards
Only a few companies seriously attempted to independently ap praise risk. For most, the extent of independent appraisal was the test of company experience. For example, management attempted to predict the range of earnings available for debt servicing. An analysis of the margin of historical earnings over debt servicing charges was prepared. This became the standard for borrowing em ployed by management. As long as earnings were comfortably in ex cess of maximum debt servicing requirements the financial manager was satisfied. If the company survived adversity without causing financial embarrassment, the decision rule was considered adequate. 75
If experience proved the rule too liberal, it was modified.
The most sophisticated analysis of debt and risk was discovered in a rapid growth company which required substantial amounts of funds for continued expansion. Utilizing income and balance sheet data, management prepared a flexible budget of cash flows under assumed adverse conditions. Cash flows were then compared to actual and potential levels of debt servicing. A description of the method em ployed follows: A projection of net income after taxes was calculated.
To net income was added non-cash charges in order to approximate cash inflow. These sums were then offset against a comparable level of expenditures for plant and equipment, working capital requirements,
(if any) and dividends. It was assumed that certain minimum capital expenditures would continue in adversity, i.e., those capital pro jects under construction or contract. Dividends were assumed to decline to zero in adversity. The net result indicated the extent of additional cash outflows for debt servicing capable of assumption without jeopardy to the cash position of the company. Hence, if the company experienced a research "break-through," debt necessary for the project could be supported.
The following format was employed by the company:
Net income after taxes (in prosperity and adversity)
+ non-cash charges
- plant and equipment expenditures
- working capital expenditures
- dividend expenditures - debt servicing
= net cash flow available for future debt servicing.
In attempting to resolve the risk problem, management's primary concern became the formulating of an estimate of the company's ability to make debt payments in adversity. This was one of the few indica tions discovered of an attempt to arrive at an independent risk stand ard .
During the interviews financial managers frequently made ref erences to the importance of experience in formulating risk policy.
For some executives, new to the finance committee, recession experience was distinctly limited or totally lacking. Moreover, due to personnel turnover, variation in this experience within the same company was found to be substantial. Therefore, the value of personal experience as a guide in decision-making may be overemphasized.
In summary, the evidence as to the sources of company standards of debt capacity Indicates reliance primarily on the judgment of others and little independent evaluation. Independence was limited to a choice of the external information necessary for establishing the appropriate standard, but management lacked an objective basis upon which to make a rational decision. There was, of course, the test of experience, of trial and error, but this assumed that the adverse effects of an in appropriate choice were not so severe as to preclude subsequent modifi cation. 77
The dependent and Independent reference sources for the for mulation of risk of borrowing rules have been examined and evaluated.
Our next objective is to examine and appraise the tools of analysis
employed by the financial manager in formulating a borrower risk policy
for a particular company. CHAPTER V
BORROWING DECISION RULES EMPLOYED BY MANAGEMENT
This chapter is concerned with the usefulness of the borrowing rules employed by business practitioners. The chapter has two ob jectives: To examine the appropriateness of management risk criteria and to evaluate the validity of the borrowing standards in use by management today.
The chapter is divided into three parts. In the first part the external and internal borrowing rules employed by management are examined and evaluated. The external borrowing rules, formulated from sources outside the company, are a predetermined interest rate ceiling and minimum bond rating on new debt financing. If the debt
issue is within these borrowing standards, it is accepted. If not
it is rejected.
The internal borrowing rules, formulated from sources within
the company, are of a quantitative nature. They are long-term debt
as a percentage of net tangible assets and earnings coverage. If a
proposed debt issue satisfies these predetermined borrowing rules,
it is accepted. Otherwise, it is rejected.
The second part is an examination and evaluation of continuous
and discontinuous borrowing approaches to risk. The single project
and rapid payback discontinuous decision rules are presented and
evaluated. 78 79
The final part is a presentation and evaluation of the impact of debt servicing (principal and interest payments) and restrictive indenture covenants on the risk of borrowing.
The information in this chapter represents the practices, opinions and attitudes of the financial managers of the companies in the sample and the author's evaluation thereof.
In spite of opposing arguments concerning the Issuance of debt, most managements were able to develop debt decision standards which re solved the risk problem. However, these standards remained relatively inflexible over extended periods. Therefore, the actual process of formulation was often indistinct. In the interest of clarification, not all companies possessed a debt policy, i.e., a clearly articulated standard, which influenced debt decisions. Executives admitted that the capital structure had evolved haphazardly. Moreover, profitable managerial experience tends to support individual debt decisions and confirm the soundness of the resulting capital structure.^
External Risk Decision Standards
Capital Market Interest Rate Criterion
One common managerial approach to the control of risk is the establishment of an interest rate ceiling on debt capital. In the extreme, funds will be required only if^available at or below a pre determined rate which fluctuates with variations in long-term "AAA"
1Ibid. 80
rates. Financial managers stated that a margin of safety is provided in the differential between the maximum acceptable rate, as defined by conservative financial institutions, and the predetermined managerial rate. To the creditor is delegated the task of deciding the exclusion 2 point of additional debt financing.
Such a decision standard appeals to the borrower because the emphasis on analytical skill is eliminated. In addition, the standard is erroneously believed to be consistent with profit maximization.
Regarding corporate investment, profit maximization is equated to cost minimization. As discussed earlier, those companies that accept in vestment limits other than the availability and cost of capital do not think in terms of net incremental return from potential investment op portunities. Rather, they attempt only to minimize the interest cost on new debt capital.
The coupon rate on long-term debt is appraised independently of any profit maximization goal. The ability to finance within a specified interest rate is considered unquestionable evidence of rank within an industry and a proof of managerial success. Some financial managers believe that such status symbols should not be discarded merely to increase return on investment. The importance of this con sideration cannot be measured but it is important in some decision making and has no direct relation to concepts of risk-bearing capacity
such as a debt limit implies.
2 A similar finding was reported by J. Fred Weston, "Norms for Debt Levels,11 The Journal of Finance, IX (May, 1954), pp. 124-135. 81
Borrowing the Maximum Available with a Previously Selected Bond Rating
Debt issues are often floated only .if future bond ratings would not decline below a previously assigned minimum rating for the company's bonds. This risk standard, however, is applicable only to publicly issued bonds. A margin of safety is believed to be provided by the establishment of a bond rating reasonably above the minimum ac ceptable rating to the suppliers of debt capital. Because the stan dard reflects the arbitrary adoption of an external criterion, ap praisal of risk by the financial officer is avoided.
Every company interviewed agreed that a "Baa" or "BBS1rating was the minimum affordable for retention in the portfolios of major institutions. However, some businesses publicly sold bonds rated below the "BBB" category. To the extent that borrowers prefer to associate only with "respectable" financial institutions, the ease of obtaining funds is reduced if the quality rating is below "BBB". A financial officer is more comfortable in negotiating a debt contract if the rating is "BBB" or above. Further,, a debt limit which pre serves a "BBB" rating for ordinary debentures may assure a cushion of 3 additional borrowing power in an emergency.
In summary the approaches to debt policy that have been con sidered have either avoided the problem of appraising the risk
A similar finding was reported by James J. Scanlon, "Trends in Corporate Finance," Public Utilities Fortnightly, LXXI (March 28, 1963), pp. 15-27. associated with debt or delegated the responsibility to those who are supplying the debt capital.
Internal Continuous Borrowing Risk Decision Standards
We now turn to those approaches to debt policy that have ex plicitly or implicitly recognized the responsibility of the borrower in making his own independent appraisal of risk. Typically these restraints take an objective and relatively uncomplicated form which are often described as "rules of thumb*" though they are not neces sarily employed in the undiscriminating manner that this term implies.
By far the most common of these standards is that in which a specific limit is placed on the principal amount of long-term debt as a per centage of the total permanent capital of the business. There are, however, other standards that have distinctly different form and im plications, and a description of all observed variations follows.
Total Long-Term Debt as a Percentage of Net Tangible Assets
Classical financial theory treats debt magnitude in terms of balance sheet values, i.e.,-the principal amount of debt is compared to owners' equity. Restraints on the assumption of debt are expressed as an absolute percentage. This percentage is defined as: total long- 4 term debt to the sum of total long-term debt plus total equity. How
4 Guthmann and Dougall, loc. cit. , p. 276. 83
ever, in convertible subordinated debenture contracts the standard is
is usually expressed as a percentage of total long-term debt to the dif ference between total tangible assets and total current liabilities
(net tangible assets). A common decision rule forbids long-term debt to exceed 35 per cent of net tangible assets. As a practical guide such a standard is free from differences of interpretation. Further, the absolute limit on the amount of debt outstanding is adjusted for any variations in retention of earnings or conversion of debentures.
The per cent of net tangible assets limit has two distinct man agement applications. By some, the standard is taken literally as the maximum amount of debt a company may issue, if debt is the most favor able financing vehicle. By others, th^ standard is a theoretical limit for the safe assumption of debt. The limit was never reached in the companies interviewed because a reserve of debt capacity was maintained as protection against unexpected embarrassment. The determination of an adequate margin between the theoretical and practical limits was indefinite because of an inability to measure the unexpected. Period ically, the expansion of plant, property and equipment forced debt toward the theoretical limit and caused management to initiate action to decrease the percentage of long-term debt to net tangible assets.
Having examined managements1 implementation of the per cent of net tangible assets borrowing rule, we will now evaluate this quanti tative decision standard. Convertible subordinated debenture lenders and borrowers universally express risk-of-debt as a fraction of net 84
tangible assets. To be meaningful, changes in the percentage must reliably reflect changes in the degree of risk. Moreover, this re lationship must be simple and direct, i.e., the higher the proportion of long-term debt, the greater the risk of cash insolvency. Thus, a constant percentage could be interpreted as a stable risk factor.
Balance sheet percentages are unreliable risk standards for industrial borrowers because debt can change significantly with no alteration in risk and vice versa. This is because long-term in dustrial debt requires a periodic sinking fund payment."* As the debt proportion declines, the annual cash drain for the sinking fund remains constant. The declining debt proportions may decrease in vestor risk as measured by asset values, but the risk of cash in solvency is not diminished, except with respect to net bond interest payments, until the debt is fully repaid. In a sense, risk may in crease since a balloon sinking fund payment may be required if con version is not forthcoming.
Prospectuses of companies interviewed reveal that total sink ing fund payments typically represent 70 per cent of the debentures issued. The hazard to cash insolvency varies according to the term and amount of the sinking fund payment, the decision on balloon pay ments and the exercise of the conversion option. Simple debt-equity proportions do not reflect such variations.
A discussion of the sinking fund provision is included in part three of this chapter. 85
Some additional ways in which the balance sheet standard does not adequately measure risk are as follows: The amount of convertible subordinated debentures is established by contract, whereas, the asset values appearing on the balance sheet are subject to management dis cretion. To illustrate, changes in inventory values and depreciation rates affect the per cent of net tangible assets but need not influence to the same extent the amount or titling of cash inflows. Investment bankers are attentive to off-the-balahce sheet items, e.g., lease con tracts, which increase the probability of cash Insolvency. Further, changes in the composition of assets, although not affecting the per cent of net tangible assets, may influence cash insolvency.
Minimum Earnings Coverage
The earnings coverage decision rule limits the dollar amount of annual interest and sinking'fund payments. Expressed as a ratio,
this standard appears as follows:
Available Net Earnings (Before Taxes)
Interest +
Since the primary purpose of the standard is protection in adversity,
the numerator is an estimate of the average level of future earnings.
The resulting margin of coverage allows for temporary contractions in
earnings below the expected average level. Thus, some managements 86 believe the possibility of insolvency is avoided if a minimum earnings coverage ratio of four is maintained.
The primary advantage of earnings coverage is that it does not have a built-in dependence on the judgment of the creditor. It implies an independent borrower appraisal of risk with outstanding debt being adjusted for variations in expected earnings. Moreover, the use of an earnings coverage standard is an advancement in relating the decision rule to the risk of insolvency. This is because earnings coverage shifts attention from assets to earnings and from the principal amount of debt to the annual outflow for debt servicing.
In spite of its advantages, however, two factors detract from the usefulness of the earnings coverage standard. Solvency is pre served if the ability to make cash payments on time is assured. How ever, it is questionable whether net earnings sufficiently represent cash available for debt servicing and whether minimum coverage re quirements are adequately determined. Some analysts convert net income to cash flow by adding non-cash expenses to net income. With this exception, however, the ratio relates the annual cash burden of debt to net income as defined by the conventions of accrual account ing. Under certain circumstances net income, when adjusted for non cash expenses, can approximate net cash inflow. However, adjusted net income for industrial companies may be a misleading indicator during adversity.
The most obvious discrepancy in the earnings coverage standard is that between sales and cash receipts. As long as the level of sales 87
gradually changes, the differences can be Ignored. However, a sudden appreciable change will produce significant differences. Likewise, cost of goods sold and expenditures for goods produced differ widely, the latter being the cash consideration. Such facts are not apparent from the income statement.
Similarly, other items important to management are not con sidered in an earnings coverage standard. Capital expenditures are sometimes provided for. by excluding non-cash expenses from the income statement on the assumption that they will nullify each other. Divi dend payments are comnonly dismissed because they are discretionary.
However, because risk is being evaluated for management, these de mands on cash, which are discretionary, may be considered mandatory for decision-making purposes.
The lack of a built-in guide to a desirable margin of safety is the second limitation of the earnings coverage criterion. Investment literature stipulates minimum permissible ratios for investment pur poses.^ Commonly, earnings coverage ratios refer to broad industry groupings and are not refined beyond the category of industrials, railroads and public utilities.7 The ratios are expressed in multiples of one (2:1, 3:1), and distinctions beyond a .5 differential (2 1/2:1 vs. 3:1) are seldom drawn. When translated into amounts of debt the
^Benjamin Graham, David L. Dodd, Sidney Cottle and Charles Tatham, Security Analysis (4th ed.; New York: McGraw-Hill Book Company, 1962), p. 348.
7Ibid.
I 88
distinctions are crude, and a choice between 2:1 and 3:1 or 2 1/2:1 and 3:1 will profoundly affect the permissible debt burden.
In attempting to formulate a workable risk policy, financial managers rely on the earnings coverage and per cent of net tangible
assets decision rules. However, the operational earnings coverage
standard, e.g., 2:1, is derived from the advice of institutional
investors or investment bankers. In only a few cases do the decision
rules reflect the borrower's attitude toward risk-bearing. Its use
does not seem to indicate an attempt to measure individual risk by
some objective means.
Discontinuous Borrowing Risk Decision Standards
Those managements adhering to earnings coverage and per cent
of net tangible assets decision standards, viewed debt financing as a
continuous process. Where the minimum acceptable level exceeded the
actual ratio, usable risk-bearing capacity was thought to exist and
new long-term debt commitments are appropriate. Such a borrower risk
policy is based upon the inherent characteristics of the business and
its environment.
In contrast, other companies interviewed pursued a discontinuous 8 borrowing approach to risk appraisal and debt financing. Management
8 A similar finding was reported by Harry C. Sauvain, "Has Business Borrowed too Much," Business Horizons, I (Winter, 1958), pp. 48-65. — 89 discouraged continuous employment of long-term debt but occasionally approved of a limited utilization. Such a borrower debt policy was a function of the "risky" and "safe" investment projects being evaluated. Risky projects were financed with equity. Relatively safe projects were financed with debt. Thus, each financing decision required a fresh appraisal of borrowing and project risk.
The Discontinuous Single-Project Approach to Risk
All companies in the aerospace industry considered recurring fluctuations in revenues and earnings too severe to justify long-term debt as a continuing source of funds. On the other hand, all agreed that investment opportunities could arise for which debt financing would be appropriate. An example frequently cited by aerospace finan cial managers was the acquisition of a going concern. In such cases the financial manager considered debt financing because payback was more measurable and assured than for internal investment opportunities, e.g., new product development. Consequently, in a comparatively risky business where permanent debt might be inappropriate, specific invest ment opportunities may arise which are deemed to involve less risk than that risk posture characteristic of the entire business. Here debt financing was considered appropriate. 90
The Discontinuous Payback Approach to Risk
At certain intervals in the life cycle of a company, manage ment may have more confidence in the cash flows of the immediate than
the more distant future. In the aerospace industry, the presence of an unusually large sales backlog is indicative of such a situation.
Given assurance of a substantial cash throw-off , some companies are - willing to assume a modest amount of debt in expectation of its con version or early repayment. Funds so attained are quickly replaced by equity, and debt is considered temporary. The rapid payback ap proach, consistent with the long-term policy of financing growth from retained earnings and common stock, is considered a means of handling
such unavoidable peaks exceeding current internal generation.
Managements of aerospace companies distinguished between the
levels of risk associated with different investments. They investi gated the possibility of debt financing for the less risky and the exclusion of debt for the more risky. One aerospace company would not consider debt financing for the production of an untested product but, confident of a rapid payback, would utilize debt to acquire a profit
able company. This approach appeals to a high-risk company, i.e.,
aerospace manufacturing, which is confronted with an investment op
portunity in an unfamiliar risk category. As such, the debt-equity
proportions become the by-product of the balance of risky and relative
ly safe investments and automatically change with a shift in invest ments. Hence, the capital structure becomes a.function of the in vestment opportunities accepted by the company. 91
Continuous and Discontinuous Borrowing Approaches to Risk
One of the major considerations in the development of a risk policy is the question of whether it is to be applied on a continuous or discontinuous basis. It is apparent that the expected advantage of debt leverage in which the earning capacity of equity capital is extended by borrowing at a low fixed rate and investing at a higher rate is a function, not only of the rate differential and of the pro portions of debt in the capital structure, but also of the period of time over which the leverage is exercised. Recognizing this, some companies take a positive approach to the use of debt and think of borrower risk in terms of an "ideal" or "optimum" capital structure toward which management should always be striving. Other companies in the sample take an essentially negative approach to the use of debt. They think of it as something which under the pressure of circumstances may be assumed up to some "reasonable" level but should be minimized and if possible eliminated as quickly as needs and alter native resources permit. These differing approaches are apparent in the observed practices with respect to borrowing rules described earlier. Whether a continuous application^of risk is feasible and, if so, under what circumstances, becomes a paramount consideration in the development of a risk policy.
The present attitude of institutional lenders and the form of industrial convertible subordinated debenture contracts are detrimental to continuous leverage. Industrial convertible contracts usually follow a straight-line schedule of sinking fund payments. Such sink ing fund payments are related to Income generation and the capacity to replace debt with internally generated equity capital rather than to the need for funds and their possible release from active employ ment.
Variations in the availability of debt capital at favorable 9 interest rates adversely affect continuous borrowing. Financing decisions are influenced by periodic fluctuations in the business cycle. An abundance of "cheap" debt capital is unlikely to impel debt proportions to exceed the accepted upper limit established by manage ment. However, a shortage of "cheap" debt capital coincidental with a need may cause debt proportions to decline below a minimum accept able level.^ Such variations in outstanding debt are also detrimental to continuous leverage. Moreover, the variations in leverage may ad versely affect the four stock market criteria employed in selecting alternative sources of funds.
Apart from practical limitations on sustained borrowing, con sider the logic of a continuous debt leverage policy. If basic risk considerations do not change, uninterrupted risk-bearing seems reason able. However, a change in the factors affecting risk would necessi
tate reappraisal and adjustment of the debt burden.
9 J. Fred Weston, "Timing of Financial Policy," The Controller, XXIX (December, 1961), pp. 596-600.
10Ibid.. p. 598. 93
If the benefits of financial leverage are desired, management is obligated to preserve the maximum appropriate debt. To permit or deliberately plan for a substantial debt reduction implies one or more of three conditions: (1) that considerations other than income maximization are governing policy; (2) that management is adjusting to worsened conditions; or (3) that risk is excessive and management is
seeking to restore a reasonable level of debt.
While managements of companies interviewed considered it neces
sary to periodically increase debt funds, an unwillingness existed to continuously bear this risk over a period of time. Consequently, all managements chose the first opportunity to reduce outstanding debt.
Beyond this, however, many admitted the failure to comprehend the magnitude of risk associated with debt and, therefore, the inability to determine the appropriate level. While conservative management might
borrow in accordance with investor's standards or general industy
practice, the fear remained that risk might be excessive. The obvious
solution was debt reduction.
Other Risk Decision Factors
In imposing restraints on debt capacity, borrowers and lenders
are concerned primarily with limitations on the principal outstanding.
Such emphasis is derived partially from the traditional interest of
creditors in the recovery of assets in the event of bankruptcy or
liquidation. However, concern with the principal also originates with 94
the burden of debt servicing which is roughly proportional to debt outstanding. Thus, a restraint on the principal outstanding is a direct constraint on the amount of debt servicing.^
In practice, the risk-conscious borrower will negotiate the
principal and then explore methods of minimizing risk. The vigor of
this exploration and the concessions made for a reduction in risk
depend upon the degree of risk imposed by the size of the loan and
the receptivity of investors to risk bargaining.
It is a generally accepted financial axiom that the magnitude 12 of debt servicing is dependent on the duration of the contract.
Recognizing this, some borrowers minimize the annual charge for re
payment of principal and increase the probability of conversion by
extending the period of the contract. For example, a debt issue of
$1,000,000, assuming the absence of a conversion option, at a given
interest rate of 4 per cent would have, assuming the sinking fund is
not used to retire the debt until its final maturity, a maximum annual
servicing charge of $140,000 if negotiated for 10 years and fully re
tired by maturity; $90,000 if negotiated for 20 years; and $73,000
(figures rounded) if negotiated for 30 years. While a borrower may
lack a choice of maturity dates, a limited variation is possible.
^Hfeston, loc. cit., pp. 125-126.
12 Guthmann and Dougall, loc. eft*, P* 218. 95
Usually convertible subordinated debenture borrowers may choose a "balloon" sinking fund payment at maturity or a full sinking fund pay-down. The amount of any final payment is negotiable. The extent
to which the balloon payment is larger than the periodic repayments of principal prior to maturity is directly related to borrower risk.
If the balloon can be converted or refunded, risk is decreased. If however, these assumptions cannot be made with complete assurance,
it becomes necessary to assess the hazard of the large final payment as opposed to the smaller regular payment.
Violation of debt covenants threatens the debtor-creditor
relationship and the existence of the business. An example is the maintenance of net working capital above a level specified by the
contract. Management must continuously scrutinize the level of net working capital to assure conformity with the debt contract. Thus,
the covenant is, at best, an annoyance or, at worst, a real hazard.
Some borrowers are able to avoid the risks of restrictive
covenants. One financial officer insisted upon conditional rather
than absolute covenants. Instead of a requirement that net current
assets remain above "X" million dollars, he requested that, should
net current assets fall below "X" million dollars, dividends would be
suspended until the position was restored. Thus, the covenant would
not be a condition of default but would -require remedial action.
Management's concern with opportunities for risk minimization
vary widely. Some negotiate vigorously with respect to the interest
rate; others have an inflexible attitude toward the acceptability of terms and covenants. However, a managerial desire to exchange in terest rate concessions for major modifications of the risk element is not evident from the research findings. In general, active ex ploration of opportunities for risk minimization occur only within the first companies in each industry to issue convertible subordinated debentures. This is because a precedent does not exist to influence the financial manager or the investment banker. After the first company issues convertible subordinated debentures a precedent exists for other companies in the same industry.
This chapter has presented the significant observations de rived from a study of business practices with respect to risk-of-debt policies. Its purpose has been to relate, in an accurate and unbiased form, current management thinking and practice within a sample of in dustrial companies. At the same time, it seemed appropriate to evalu ate the adequacy or soundness of individual management practices. A secondary purpose was to stimulate a constructively critical attitude on the part of the reader in reviewing this sample of present-day business practices. The remaining chapters are devoted to a proposed method for developing an independent appraisal of the risk implica
tions of long-term debt. CHAPTER VI
A PROPOSED RISK STANDARD: CASH FLOW ANALYSIS
Management behavior regarding the risk-of-debt and existing risk standards has been examined. This examination motivated an evaluation of the conventional risk criteria. The serious limita tions of these management criteria initiated an exploration of al ternative approaches to the risk decision. This phase of the study is devoted to the development of a better method for examining risk.
That present risk standards are derived from external sources, are cast in a form more appropriate to the lender than the borrower and fail to provide a means of relating the standard to individual company circumstances are shortcomings of conventional risk evalua tion. Because a borrower must necessarily consider external opinions in formulating a risk policy, no attempt is made in this study to replace existing risk rules. Rather, the aim is to reduce manage ment's dependence on outside opinion and to formulate appropriate modifications of risk policy consistent with individual management circumstances. Thus, the behavior of cash flows will be examined with particular attention given to the circumstances under which shortages of cash might threaten the ability of the financial manager to fulfill cash commitments.
Formulation of an approach to the problem of risk required a determination of the possibility of cash insolvency resulting from
97 98 existing and contemplated debt contracts. Recognizing that many cir cumstances could precipitate cash insolvency, the sample companies were primarily concerned with surviving a'possible recession. There fore, the behavior of cash flows in adversity became the nucleus of the investigation.
Recent developments in the application of cash budgeting to financial decisions have enabled the sample companies to successfully forecast cash flows. Unfortunately, however, cash forecasts are lim ited to the period over which projections can be confidently prepared.
While such forecasts provide information concerning the probability of immediate insolvency, a useful tool of analysis has yet to be developed for the long-term debt contract.
At present, future cash flows are predicted largely from past experience. Unqualified acceptance of past impressions as an ade quate prediction of the future has proved objectionable. Conse quently, a method for employing the evidence of past experience, which avoids the fallacy of blindly extrapolating cash flows from the past, must be ascertained.
The Determinants of Cash Flow^
An appraisal of risk must involve all dimensions of cash flow because cash insolvency cannot be segmented. The components of cash
^In substance this treatment of the determinants of cash flow was derived from articles by Almand R. Coleman, "Funds Statements and Cash Flow," The Controller, XXIX (December, 1961), pp. 592-595 and Perry Mason, "Cash Flow Analysis and Funds Statements," The Journal of Accountancy. CXI ((larch, 1961), pp. 59-72. inflow and outflow will be referred to as the determinants of cash
flow. To assist in simplification, symbols, relating to the first
letters of the words or phrases represented, will identify the pri mary determinants. Of ultimate concern is the probability that fu
ture net cash balances (CB^) will be involuntarily reduced to zero.
Assuming no new borrowing or stock sales, this will occur if net
cash flows during the recession (NCF^) become negative and the def
icit flow exhausts cash balances at the onset of the recession (CB ). o This relationship may be expressed in general terms.
CB = CB + NCF r o — r For the moment, consider the entire recession as one interval. The
critical segment of time extends from a peak to the depths of the
ensuing recession or, if net cash flow (NCF) is negative, to the
point at which it again becomes positive.
In selecting a format, either a purely cash description or a
conversion of accounting data into cash equivalents may be chosen.
Since primary cash flow data are accessible to the internal analyst, he need not resort to conventional accrual accounting statements.
However, because the external analyst's study originates with account
ing records, the components of cash flow will be described here in
cash and accrual accounting terms. 100
Net cash flow can be illustrated as follows:
NCF = (C + OR) - (P + RM + . . . + E ) r v s a n where:
C represents collections from sales s OR represents other receipts in cash form
P represents expenditures for payroll
RM represents expenditures for raw materials
represents all other nondiscretionary cash expendi
tures.
Using balance sheet and income statement data, net cash flow may be demonstrated in the following form:
NCFr = { ^ 0 + S ‘ + 0C} " \ [CGP + SGA + T] +
[(APq - APX) + (AEq - AE^]} where:
ARq represents accounts receivable at the beginning of
the period
AR^ represents accounts receivable at the dnd of the
period
S represents sales
OC represents other cash received
CGP represents cost of goods actually produced
SGA represents selling, general and administrative expense
T represents federal income taxes paid
APq , AP^ represents accounts payable
AEq , AE^ represents accrued expenses. In order to convert credit sales into gross cash inflow add credit sales to the beginning balance of accounts receivable and deduct the ending balance of accounts receivable; the result is gross cash inflow arising from credit sales. In contrast, cost of goods produced represents a variation from cost of goods sold, be cause non-cash expenses are ignored, for purposes of this study, and orders may be filled from either inventory or current production.
Finally, the various legitimate expenses are converted into expen ditures by accounting for changes in accounts payable and accrued expenses. Thus the two statements of net cash flow will produce similar results.
NCF = Inflow - Outflow
Cash Flow C + OR P + RM . . . + E s a n Accounting ^(ARQ + S - A R ^ + OcJ £[CGP + SGA + T] +
[ (APq - A P ^ + Collection of the Data All firms in the sample prepared a statement of cash receipts and disbursements. As the title indicates, historical causes of change are enumerated. Transactions are classified according to the major sources and uses of cash. The difference between the recorded inflows and dutflows represents the diversity between the opening and closing cash balances. While management prepares the statement 102 to evaluate the precision of cash budgeting, this study is concerned with flows of cash. Therefore, additions to the cash account from short- and long-term borrowing arid stock sales were deleted. Classification of Disbursements Identification of causal relationships necessitates the fol lowing classification of items of cash outflow. (1) Cash expenditures related to the volume of sales, physical levels or dollar value. (Examples--salesmen 1s commissions, freight on sales, sales taxes.) (2) Cash expenditures pertaining to the number of units pro duced. (Examples--purchase price of component parts, direct labor, direct materials, freight on raw material purchases.) (3) Cash expenditures influenced by managerial policy. Ad justment is often in the form of steps rather than a continuous func tion. (Examples--advertising and sales promotion, research and development, legal services, consulting services, supervision, in direct labor.) (4) Cash expenditures related to the level of net income. (Examples--state and federal income taxes, bonus plans, profit shar ing agreements, preferred and common stock dividends.) I (5) Cash expenditures beyond managerial control which respond to factors other than the current level of sales, production or net income. (Example--heat and ligh't expenditures influenced by weather conditions.) 103 (6) Cash expenditures which are fixed in amount and/or timing of payment for two or more years. (Examples--lease payments, interest and sinking fund payments, insurance premiums, property taxes, equipment installment payments, contracted salaries.) Recession Behavior of the^Determinants of Cash Flow Theoretically, sales can decline to zero in the future. How ever, business experience does not accept this as a valid framework for decision-making. Assume a single product firm selling entirely on credit. Concentrate on dollar volume of sales and the collection period. In a mature company the sales volume will not decline to zero and the collection period expand to an infinite number of days because of proven management arid acceptable profit performance. While confident prediction of the occurrence, severity and duration of a recession is impossible, management can establish finite limits on its expected impact. To illustrate, assume the contraction in dollar sales has never been less than 5 per cent of the sales of the preceding peak period or more than 25 per cent (measured at the lowest point of the recession). Although management has no basis for predicting the timing, magnitude and duration of the next recession, the contraction in 2 In substance this treatment of the behavior of the deter minants of cash flow was derived from Richard M. Cyert and James G. March, A Behavioral Theory of the Firm (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1963), Chapters 6 and 9. 104 sales is assumed to be between 5 and 25 per' cent. For the moment, ignore the timing of this reduction. These limits will be referred to as absolute favorable and absolute adverse. The terms "favorable" and "adverse" refer to the expected impact on cash flows. The term "absolute" refers to the maximum range of contraction in sales. Be cause of a preoccupation with the event of cash insolvency, the adverse limit is of greatest interest. From historical sales data a "frequency distribution," useful in predicting future expecta tions, can be prepared. An example follows: Recession Percentage Over-all Number Sales Contraction 1 5 2 13 3 18 4 22 5 23 6 25 An Operational Approach to Risk The construction of a probability table is now feasible. How ever, our primary concern, operational analysis, motivated a re appraisal of the utility of a probability approach to risk. Professor Gordon Donaldson, of Harvard University, stated three obstacl*es to a probability approach to. risk--the complexity of the analytical 105 process, the difficulty of deriving the probability data and the 3 arduous task of motivating management to undertake such an analysis. Methodology is an obstacle because the use of appropriate methods requires mathematical skills foreign to most top managements. 0 In addition, generating probability distributions of the behavior of cash flow determinants requires management to forecast the oc currence of events and to participate in an unfamiliar analytical j process. The lack of motivation complicates the collection of the probability data. Many businesses desire such information but are unwilling to consider a radical departure from present practice. The majority are reluctant to base a critical decision on an ana lytical process involving a methodology and degree of refinement inconsistent with conventional practice. Since the availability of critical data requires the participation of management, current 4 prospects for the application of a probability analysis are remote. Therefore, the research goals were defined in terms of data presently available and acceptable to management. The result is a simulation analysis of the adverse limits of cash flow behavior. Gordon Donaldson, "New Framework for Corporate Debt Policy," Harvard Business Review, XL (March, 1962), pp. 117-131. 4Ibid. 106 The Cash Balance . A necessary test of continued operations under adverse cir cumstances is the cash balance immediately prior tb a recession, CB . As a defense against unpredictable adverse events, liquid o reserves are a critical element of cash flow analysis. They are intimately linked with risk policy and considered with unused debt capacity as a cushion against risk. Thus, consideration of appro priate levels of cash balances must be included in risk appraisal. Cash balances are often maintained at high levels to substi tute for careful planning and accurate forecasting. Some companies interviewed deliberately reduce them, because cash is an unproduc tive asset and full employment of resources maximizes profits. Most managements avoid excessively low balances which may create a tempor ary inability to make timely payments as well as high balances which encourage complaints of inactivity, foster demands for higher divi dends and invite corporate raiders. To some degree, cash balance is the incidental by-product of the level of earnings, non-cash charges, dividend payout and capital expenditures. Most companies interviewed evidence an unplanned var iation range between the acceptable lower limit, when management deliberately increases liquidity, and an indefinite upper limit where management augments capital expenditures or dividends. Our concern is with the lower limit, its relationship to the level of sales and operations and the differences between this level and the actual cash balance. 107 Any assumed minimum cash balance must be compared with the current level to discover an excess or deficiency. If maintenance of generous cash balances has been a consistent policy, the abso lute adverse value may be substantially above the minimum previously derived. Consequently, the initial balance, CBq , may provide cash to offset net cash outflow, NCO. The Problem of Timing' . The timing of the sales contraction is of utmost importance in determining if the cash balance becomes negative. Moreover, be cause various determinants respond differently during adversity, it is dangerous to deal only with net change. To include timing in creases the complexity of the analysis but fails to alter the basic concept. The symbolic description of net cash flow by periods is: NCF][ = £(ARq + Sx - AR ^ + 0C1J - {’[CGP1 + SGA1 + T ^ + [ (A?o " ^i ) + NCF2 = | >(AR1 + S2 - ARp + OC^ - { [CGP2 + SGA2 + T2] + [(AP1 - AP 2) + (AEX - A E 2 ) ] | and so on for n periods. Thus, net cash flow for the relevant recession period (NCF^) would be: NCF = (NCF + NCF + . . . + NCF ). r 1 2 n Whether the 25 per cent sales contraction is concentrated or distributed over the entire recession affects the result. Assume the absolute adverse period to be four years and two-fifths of the 25 per cent contraction concentrated in the first year with the 108 balance apportioned equally over those remaining, Considering the possibility of an immediate recession and assuming a prosperity sales level of $80 million (S^) , the absolute adverse pattern would be: $72,000,000 68.400.000 64.980.000 61.731.000 Having determined sales, it is possible to produce the abso- lute adverse limit of Cg. In some companies, collection experience is closely related to sales volume; in others, it is independent. The following observations are pertinent to the collection period associated with the sales levels of an office equipment company in the sample: (1) The collection period invariably lengthens at the outset of a recession. The longer and deeper the recession, the more lengthy it becomes. (2) The average number of days' charge sales uncollected has never been less than 30 or greater than 80 days. (3) Given a collection period in year zero in excess of 30 days, the expected time interval will range between that value and the upper limit. (4) Thus, the collection period associated with the absolute adverse sales level of $61,731,000 would be 80 days. 109 The Anticipated Limit Because an event having a remote probability of occurrence is being considered, the usefulness of absolute adverse net cash flow is limited. Assume the behavior of each primary determinant of cash flow is independent of the others and that an uncommon tendency exists to reach absolute adversity in the same recession period. The probability of experiencing adverse net cash flow for the combined limits of all the determinants is more unlikely than for any single limit. A remote likelihood of occurrence exists for a net cash outflow associated with the absolute adverse assumptions. Thus, it is desirable to locate another reference point with which to compare the absolute adverse limit. This quest led to a determination of the anticipated limit of adverse behavior. To express these ideas graphically, Chart 4, the frequency of sales contractions, was constructed. Assume these frequencies are normally distributed about the mode. Where the curve begins is the absolute favorable limit and where it terminates is the absolute adverse limit. The frequency of sales contractions reaching the absolute adverse limit is minimal by definition. The precise origin for the anticipated limit is inexact because the data is continuous. However, a critical section exists at each extremity where the curve approximates a parallel position with the horiaontal axis near zero frequency. Actual experience will lead management to FREQUENCY OF OCCURRENCE Source: 0 FREQUENCYSALESOF CONTRACTIONSIN ADVERSITY yohtcl data.Hypothetical (MAXIMUMSALES CONTRACTIONCENT AS A PER FAVORABLE OF SALESOF OF PRECEDING PERIOD) PEAK CONTRACTIONINSALES LEVEL 10 IMITS ANTICIPATEDRANGE % ABSOLUTERANGE CHART 4 MODI 15% DES LIMITS ADVERSE 20 % 110 Ill determine the anticipated limit. Assume that a sales contraction of 25 per cent is the absolute adverse limit and of 20 per cent is the anticipated adverse limit. Identification of the anticipated limit is an attempt to draw a distinction, meaningful to the practitioner, without as signing specific probability values to events having a reasonable possibility of occurrence. For some determinants this method may be invalid because the experience curve may not be bell-shaped and, therefore, the anticipated and absolute limits may be identical. Nevertheless, it is meaningful to distinguish between adverse values having a remote chance of occurrence and those descriptive of normal experience. Current Condition In its present form, cash flow analysis depends oh the assumed commencement of a recession. Since debt contracts are of long dura tion and th.e onset of a recession is unpredictable, the circumstances of period zero are unknown. Further, the liquidity of the working capital position varies with major implications for solvency. There fore, it is necessary to include a statement of the limits of modi fication in relevant financial terms during peak prosperity periods. This will be referred to as the current financial condition preceding a recession. 112 Assembling the Data ^ Although no single method of assembly exists, the most use ful form for decision-making purposes was adopted. Accordingly, three basic dimensions of cash flow are: (1) The recession behavior of sales volume, (2) The recession behavior of all other determinants of cash flow (other than sales) and (3) Financial condition immediately preceding the recession. Interpretation and use of the data justify separating condi tions prior to a recession from differences in cash flow and manage ment behavior after its commencement. For example, if management wishes to avoid insolvency in advance of a recession, it will modi fy the conditions in period zero, e.g., increase CBq , improve the liquidity of 1^. The effects of variations in dollar sales are separated from other factors determining the behavior of net cash flow. Sales is the most important variable and least subject to management influ ence. Consequently, separate observation of the effect of sales is helpful in formulating a risk policy. The effect of the dimensions In substance this method of assembly and presentation of cash flow information was derived from separate studies by Gordon Donaldson, Corporate Debt Capacity (Boston, Mass.: Graduate School of Business Administration, Harvard University, 1961), Pierre Masse, Optional Investment Decisions: Rules for Action and Criteria for Choice (Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1962) and James E. Walter, "Determination of Technical Solvency," The Jour nal of Business, XXX (January, 1957), pp. 30-43. 113 of the analysis on net cash flows and cash balances at the adverse limits of behavior is described by: (1) absolute (2) anticipated. A company's financial condition preceding adversity is represented by: (3) current condition. All combinations of the assumptions of cash flow analysis are presented in Table 10. The three column headings indicate the as sumptions underlying contraction in sales, the financial condition prior to a recession and the behavior of the determinants of cash flow (other than sales) during a recession. The first row illus trates net cash flow if all assumptions are considered at their ab solute limit. Similarly, the last row exemplifies net cash flow if a recession occurs in the immediate future. Utilization of the information of Table 10 will be confined to four circumstances: (A) Net cash flows for (1) absolute and (2) anticipated lim its for all variables, assuming a desire to borrow continuously for an indefinite period. (Numbers 1 and 8 in Table 10.) (B) Net cash flows for (1) absolute and (2) anticipated limits for all variables, assuming a desire to confine borrowing to the near future, i.e., the single project and peaking need concepts. (Number 9 and 12 in Table 10*) Having developed the necessary components for a cash flow analysis, the information must be consolidated in a simple and usable TABLE 10 RANGE OF POSSIBLE COMBINATIONS OF THE ADVERSE FACTORS IN CASH FLOW ANALYSIS Financial Behavior of Determinants of Condition Cash Flow During Recession Preceding Recession Sales Other Determinants Reaches Adverse Limit Described as: No. 1 Absolute Absolute Absolute 2 Absolute Absolute Anticipated 3 Absolute Anticipated Absolute 4 Absolute Anticipated Anticipated 5 Anticipated Absolute Absolute 6 Anticipated Absolute Anticipated 7 Anticipated Anticipated Absolute 8 Anticipated Anticipated Anticipated 9 Current Absolute Absolute 10 Current Absolute Anticipated 11 Current Anticipated Absolute 12 Current Anticipated Anticipated 115 form. The dollar balances for each general ledger account in the definitional identity of net cash flow will be classified according to the four situations described above. The form designed to ac complish this purpose is indicated below. To illustrate, collections of accounts receivable are influenced by the volume of credit sales. J* All possible combinations of these variables are expressed as: Balance of Accounts Assumed Limit of Sales Receivable Preceding Anticipated Absolute the Recession______ Period Zero Period One Period Zero Period One Current $3,000,000 $2,000,000 $3,300,000 $2,200,000 Anticipated Adverse 2,100,000 1,000,000 2,300,000 1,200,000 Absolute Adverse 1,600,000 800,000 1,800,000 900,000 Similar relationships were developed for the remaining items of net cash flow. Worksheets were prepared for the classification of all items of net cash flow according to the four combinations of assumptions. Application of Cash Flow Analysis Accompanying data are derived from the experience of a sample company in the office equipment industry for 1962. This company is mature, profitable and has demonstrated the capacity to maintain a recognized position in the industry. Nevertheless, the company is 116 not disposed to finance by long-term borrowings for purposes of tax- deductible interest or the inflationary hedge of a fixed dollar ob ligation. The primary motivation for borrowing is the irregular * ] ■ timing of investment opportunities and fluctuations in the supply of internally generated funds. Given the option, management pre fers to finance entirely from internal sources. In spite of a reluctance to voluntarily employ debt, manage ment does not fear reasonable amounts of funded debt. In fact, every balance sheet of the office equipment company for the past 15 years contains some long-term debt. The board of directors of the borrowing company believes that long-term debt in excess of 35 per cent of net tangible assets should not be incurred. Application of this standard is confirmed by past issues of debt in the 25 to 35 per cent range. While the latter is extreme, 30 per cent depicts a meaningful operating limit. / Experience and expectations suggested an absolute limit of sales contraction, having a two-year duration, of 20 per cent of the sales of the preceding peak. The anticipated duration limit was one year and the magnitude of Sales contraction was 15 per cent. The information in Table 11 is the result of a determination of net cash flow directly related to the generation of current in come. Because initial cash balances are assumed to be zero, the col umns at the left illustrate the net cash flow figures which collec tively determine the possibility, motivating assumptions and magni tude of a negative cash flow from operations. TABLE 11 ESTIMATED NET CASH FLOWS ASSOCIATED WITH THE ADVERSE LIMITS OF RECESSION EXPERIENCE FOR 1962 (INITIAL CASH BALANCE ASSUMED TO BE ZERO) Set of Net Cash Flow Financial Behavior of Determinants of Conditions From Operations Condition Cash Flow During Recession in Year: Preceding Recession Sales Other Determinants One Two Reaches Adverse Limit Describee as: (A) (1) $(5,964,000) $ 1,536,000 Absolute Absolute Absolute (A) (2) 24,480,000 Anticipated Anticipated Anticipated (B) (1) 5,796,000 21,840,000 Current Absolute Absolute (B) (2) 31,128,000 Current Anticipated Anticipated Source: One office equipment company in the sample . 118 Only one set of assumptions produced a net cash outflow. When the behavior of every variable was absolute adverse, an outflow of $5,964,000 was derived. In the remaining combinations an excess of inflow was notable. In spite of further sales decline, the second year produced a small surplus of inflow. The most acceptable assumption is the anticipated limit, ex cept initially when the current condition would be an improvement. In this case, the cash .surplus was increased from $24,480,000 to $31,128,000, Table 12 regroups the data by ranking the various combinations in order of net effect on cash flow. These data suggest that any possibility of an operating cash deficit is confined to. the abso lute limit of adverse circumstances. Moreover, by definition, man agement would attach remote probability to such an. occurrence. •Those circumstances considered most'likely provide a comfortable margin of cash flow safety. While providing the data on NCF^ and the analysis re mains incomplete. Any consideration of the possibility of insol vency requires recognition of CBq , initial cash balance, which may offset any net cash outflows. Estimates follow of the cash avail able beyond that required for maintenance of the current level of operations. Idle balances furnish the primary release of cash. Only a modest amount results from the.expected decline in sales as evidenced by year two of the absolute sales limit. TABLE .12 RESULTS OF CASH FLOW ANALYSIS AS SHOWN IN TABLE 11, REGROUPED IN ORDER OF INCREASING NET CASH FLOWS (INITIAL CASH BALANCE ASSUMED TO BE ZERO) Set of Net Cash Flow Financial Behavior of Determinants of Conditions From Operations Condition Cash Flow During Recession in Year: Preceding Recession Sales Other Determinants One Two Reaches Adverse Limit Describee as: (A) (1) $(5,964,000) $ 1,536,000 Absolute Absolute Absolute (B) (1) 5,796,000 21,840,000 Current Absolute Absolute (A) (2) 24,480,000 Anticipated Anticipated Anticipated (B) (2) 31,128,000 Current Anticipated Anticipated Source: One office equipment company in the.sample 120 Assumed Level of Initial Cash Assumed Limit of Sales Balances preced- ---- ing the Recession Anticipated Absolute Period One Period One Period Two Current $3,000,000 $3,240,000 $240,000 Anticipated Adverse 1,920,000 2,040,000 120,000 Absolute Adverse 1,680,000 1,800,000 120,000 The initial cash balances will be combined with NCF^ and'NCF^ of Table 12 to produce the cumulative net cash balances of Table 13. The threat of insolvency resulting from mandatory operational cash flows is confined to the extreme limits of adverse experience. Cash Insolvency Since the risk of insolvency is within the expectations of management, any risk-bearing policy which includes continuous debt servicing will necessarily increase that risk. Further, those who believe that current debt restrictions effectively inhibit the risk of cash insolvency may be deceived. Translating a long-term debt standard of 30 to 35 per cent of net tangible assets into an equiva lent dollar amount of annual debt servicing results in an incremental cash outflow of approximately $5,160,000 to $6,240,000. Anxiety at the 35 per cent level implies that management assumed the presence of substantial risk and made reduction of outstanding debt a dominant financial consideration. However, Table 13 reveals that insolvency TABLE 13 CASH SOLVENCY AT THE LIMITS OF ADVERSITY CASH BALANCE ASSOCIATED WITH THE ADVERSE CASH FLOW ASSUMPTIONS OF TABLE 12 Set of Cumulative Net Cash Financial Behavior of Determinants of Conditions Balance at End of Condition Cash Flow During Recession Recession Year: Preceding Recession Sales Other Determinants One Two Reaches Advers3e Limit Describ<2d as: (A) (1) $(4,164,000) $(2,508,000) Absolute Absolute Absolute (B) (1) 9,036,000 31,116,000 Current Absolute Absolute (A) (2) 26.400.000 Anticipated Anticipated Anticipated (B) (2) 34.128.000 Current Anticipated Anticipated Source: One office equipment company in the sample. 122 is likely only when all determinants of cash flow are at the absolute limit. Moreover, the anticipated limit produces a positive net cash balance of $26,400,000. Therefore, the risk of insolvency is con fined to circumstances having a remote probability of occurrence. The cushion of cash available at the anticipated limit in the near future is $34,128,000. Hence, a cash outflow of $6,240,000, for debt servicing, would be insufficient to create the possibility of insolvency at the anticipated limit. The debt standard may also be evaluated by determining the most adverse combination of assump tions under which a debt burden of $6,240,000 could be borne. This is between sets (A) (1) and (B) (1). Three sets of adverse events produce a minimum cash balance adequate to cover debt servicing charges. Evidence of the remote possibility of insolvency does not represent a criticism of the 35 per cent standard. It does, however, suggest a possible misconception of risk magnitudes. Cash Inadequacy Thus far, cash flow analysis included items which were di rectly, continuously and unavoidably involved in the generation of income. Dividend payments, capital expenditures, research and de velopment and employment stabilization expenditures were omitted. However, management policy may grant priority to such expenditures in lieu of financial leverage. If additional debt servicing is contracted, it threatens to interrupt research projects or capital 123 expenditures. Management will not deliberately jeopardize these activities unless the income advantages of debt financing are ade quate to overcome such fear. Such a threat to policy expenditures is the risk of cash inadequacy. •Our concern is with the time interval during which initial cash balances plus inflows become inadequate to meet mandatory out flows and a level of expenditures dictated by policy considerations. Management of the office equipment company distributed $7,200,000 in cash dividends in 1962. Past actions and current thought indicated a disposition to decrease the dividend should sales decline. However, Management would resist a reduction below $4,200,000. Because of a likely delay in recognizing adversity and a desire to stagger any re duction, dividends were assumed to decrease to $5,400,000 during the first year and to $4,200,000 in the second year. The above average level of capital expenditures represented the anticipated limit as well as the current value. The absolute limit was estimated as 60 per cent higher. In view of a short re cession, management did not consider it practicable to initiate drastic cutbacks in capital expenditures. The lowest level of out flow in the second year was $3,000,000. A summary of capital expenditures follows: Assumed Level of Capital Expenditures Assumed Limit of Sales Preceding the Recession Anticipated Absolute Period One Period One Period Two Current $6,000,000 $6,000,000 $3,000,000 Anticipated Adverse 6 ,000,000 6,000,000 3,000,000 Absolute Adverse 9,600,000 9,600,000 3,000,000 Consolidation of Table 13 with capital expenditure assumptions and the single dividend supposition results in Table 14. Table 14 indicates that the possibility of being "out of cash" has increased. The absolute adverse situation demonstrates an inability to cover dividends and capital expenditures. Further, if other expenditures, e.g., research and development or employment * stabilization, are given precedence, debt may become a substantial menage to cash inadequacy. Consider the relationship between the 35 per cent debt limit and the risk of cash inadequacy. The expected cash balance at the anticipated limit is $15,000,000 as compared to the debt service burden (at 35 per cent of net tangible assets) of $6,240,000, i.e., in excess of a 2:1 margin. Therefore, cash inadequacy has a low probability of occurrence when confined to events within normal experience. TABLE 14 CASH ADEQUACY AT THE LIMITS OF ADVERSITY REVISION OF TABLE 13 SHOWING ABSOLUTE ADVERSE CASH POSITION AFTER PROVISION FOR ALL EXPENDITURES CONSIDERED BY MANAGEMENT TO BE MANDATORY Set of Cumulative Net Cash Financial Behavior of Determinants of Conditions Balance at End of Condition Cash Flow During Recession Recession Year: Preceding i Recession Sales Other Determinants One Two Reaches Adverse Limit Described as: (A) (1) $(19,164,000) $(26,508,000) Absolute Absolute Absolute (B) (1) ( 2,364,000) 12,516,000 Current Absolute Absolute (A) (2) 15,000,000 Anticipated Anticipated Anticipated (B) (2) 22,728,000 Current Anticipated Anticipated Source: One office equipment company in the sample. 126 Opinions of Others The safety standards of the office equipment company's sources of debt capital were examined in formulating risk policy. Although evidence of the analysis of debt limits provided by a life insurance company, an investment banking house and a bond rating agency, was vague, it was, nevertheless, significant. Customarily all sophisti cated financial analysts qualified any statements of general prac tice and emphasized the importance of judgment. With this qualifi cation, the insurance representative recommended that any office equipment company have an average earnings coverage ratio of two times debt servicing. (This was defined as the "ratio of average net earnings after bond interest, depreciation and taxes to bond interest plus tax adjusted sinking fund payments at their maximum level.") Application of this standard produced a maximum annual cash outflow for debt servicing of $9,240,000. This was above the office equipment company's 35 per cent limit of $6,240,000 but be low the anticipated limit of cash inadequacy of $15,000,000. Fur ther, the insurance representative cited a 35 to 40 per cent debt standard commonly accepted for office equipment companies. Hence, the earnings coverage standard was more liberal than a 40 per cent of net tangible assets limit which had an equivalent annual burden of $7,320,000. Examination of bond indentures indicated that the investment banker considered 35 to 40 per cent of net tangible assets as an 127 upper limit on long-term debt. This standard was.not completely in agreement with another employed by the investment banker, i.e., an earnings coverage of twice debt servicing. However, these standards were identical with those suggested by the insurance company. Evidence concerning bond ratings suggested a debt standard below 25 per cent to qualify for an "Aa" or "Aaa" rating. This was represented as an agency judgment based on experience and evaluation Of many factors. Recognizing that an "A" rating is considered the lower limit of respectability for sample company bonds, a debt limit within the 25 to 40 per cent range was suggested. Thus, management's risk standard was more conservative than that imposed by its sources of debt capital. Investors' standards were within the burden magnitudes suggested by the data at the anticipated limit. Hepce, both borrower and investor pursued a risk policy designed to protect against adverse events having a remote probabil ity of occurence. Based on this analysis the writer submitted a proposal to the financial manager of the office equipment company recommending an * elevation of the operating debt limit from 30 to 40 per cent. This would make available $21,600,000 of potential senior plus subordin ated borrowing. The incremental cost of debt was contrasted with an equivalent amount of equity capital and both compared with the expected return on investment. As long-term debt approaches the investor's lending limit, bondholders believe risk to have increased and expect a compensating rise in the interest rate. An adverse 128 change in the rating of the company's bonds is evidence of this attitude. Such an assumption was not contemplated for sample company public offerings. If a lower bond rating results from advancing from 30 to 40 per cent, then the incremental cost of the new debt is the expected interest charges on the $21,600,000 plus the pre mium paid on refinancing the outstanding debt. Thus, incremental borrowing on the cost consideration alone could be inhibited. Limitations of the Data Practical considerations, which suggested an analysis of the adverse limits rather than the entire range, imposed restraints on the data employed in formulating risk policy. Thus far the infor mation derived may be summarized: . (1) Given a company's past experience and expectations, is cash insolvency possible? (2) If so, does the evidence indicate a substantial or a remote possibility of occurrence? (3) How would additional debt servicing under an established debt standard affect cash insolvency? Would the risk of cash insol vency be substantial, remote, or non-existent? (4) Is the magnitude of the possibility of cash insolvency consistent with the^ risk expectations implicit in established debt limits? Data limitations become apparent upon consideration of ques tion (4). The sample company pursued a debt limit of 35 per cent of net tangible assets because any excess seemingly posed a threat to solvency. However, a review of Table 13 indicates that risk is less than expected and that a liberal standard is more consistent with management1s disposition toward risk-bearing. A satisfactory solution to the extent of risk assumption requires an estimate of the probability of insolvency at various levels of debt servicing. Alterations in debt outstanding can then be translated into changes in the level of risk. Three attitudes toward risk-bearing were disclosed in the field study. Some companies excluded debt from consideration if it remotely threatened solvency. For such managements cash flow analysis adequately indicates the event of cash insolvency. A pos itive cash balance at the extremes of adverse behavior measures debt servicing capable of assumption without a possibility of in solvency. Other sample companies exhibited a reluctance to employ long term debt even though risk did not seriously threaten solvency. Such an attitude was widespread among companies who financed pri marily from retained earnings but were compelled to employ debt while experiencing a temporary acceleration in growth. Management may consider additional debt servicing charges as long as cash in solvency is not threatened at the anticipated limit. To surpass this connotes that the inadequate cash balances level has been re located within a normal range of events. Risk standards then become 130 a guide to managerial affability or hostility toward the level of long-term debt. In this sense, the anticipated limit has special meaning. The last approach to risk-bearing is characterized by a man agement which is actively pursuing the income advantages of debt. Few sample companies share this viewpoint. The data of Tables 11 to 13 are useful in testing the appropriateness of existing risk decision standards. However, they will not determine, even approxi mately, the standard itself. To accomplish such a task, a proba bility analysis, which examines the chances of insolvency and elu cidates the hazards accompanying the expected rewards, is required. Managerial Influence on Cash Insolvency. Cash flow analysis identifies those determinants subject to managerial control and those to which cash flows are most sensitive. Tables 11 to 14 permit isolation of the financial condition prior to misfortune as well as the behavior of sales and all other deter minants during adversity. Normally, management cannot expect to suddenly influence sales except via a merger. However, a company can control its finances in anticipation of hardship and its responses once adversity manifests itself. Table 13 illustrates the importance of varying the financial condition preceding adversity while maintaining the other dimensions of the analysis. If sales and other determinants are considered at 131 their absolute limit and the financial condition is changed from absolute to current, the net cash balance is increased from a neg ative $4,164,000 to a positive $9,036,000. This represents a con siderable range in cash flows and net cash position. Hence, a modification of the financial structure in affluence could alter the possibility of cash insolvency in adversity. Having identified its opportunities, management may evaluate behavior modifications to improve cash flows. For example, the risk of cash insolvency was most critical during.recession year one. This suggests that any actions initiating a quicker response to a recession would improve cash flow. Inventory and production schedul ing policies, valid during prosperity and growth, could be altered in a decline with particular attention devoted to conservation of cash. Often, appropriate variations are unnecessarily delayed, and the cash position is jeopardized by insensitivity to economic change and rigidity in policy administration. Improved information, better tools of analysis, rapid communication or a change in manage ment's scale of values could modify the expected behavior of cash flows. In comparison to a reduction in the risk of cash insolvency, such costs are bearable. Financial officers indicated that decision standards, operat ing procedures and management responses are more readily implemented in adversity than prosperity. If it is possible to quicken desired responses, remove bottlenecks and minimize unnecessary absorption of 132 cash, liquidity may improve. However, the costs of such action must be estimated since any changes may be prohibitive because of the costs involved. The Lease Contract Cash flow analysis is equally applicable to a prospective lease contract decision. While equating leases to the burden of debt, many financial officers interviewed calculate the equivalent of a balance sheet value by means of a capitalization rate and in clude this amount within long-term debt on a per cent of net tangi ble assets basis. However, managements differ in their derivation of the capitalization rate. Because the proposed process requires only the contractual cash outflow, the lease analysis becomes iden tical with that proposed for debt. Appraisal of cash inadequacy indicated that contractual com mitments and policy-formulated outflows compete for available risk- bearing capacity. Cash flow analysis thus becomes a necessary preliminary to financial decisions involving fixed cash outflows. The opportunity for long-term debt financing must be evaluated in conjunction with alternative applications of contractual outflows. If the anticipated financial rewards warrant acceptance of additional fixed cash outflows but the combined risk is excessive, a choice must be made between increased debt servicing and a long term lease. Thus, it is fallacious to consider risk as constant even 133 if the rewards from financial leverage are expected to remain stable. To the extent that more attractive uses for incremental fixed cash outflows are introduced, the capacity to assume long-term debt varies. Liquidity and Flexibility Management approaches modification of risk with the knowledge that defensive measures are available in adversity. Thus, flexibil ity is provided by comfortable bank balances, marketable securities and high inventory levels. Inefficiencies in the control and oper ating procedures affecting cash flow may be justified in prosperity. Elimination of such inefficiencies must be considered when assessing the threat of cash insolvency. Unused debt capacity is a primary contributor to flexibility. The assurance of financial assistance on short notice supports manr agement peace of mind. However, the reliability of such a reserve is doubtful during adversity. Borrowing from banks and insurance companies should provide funds for new earning assets rather than to protect unproductive existing property. Thus, a reserve of risk and debt-bearing capacity exists only in a growth situation. The information produced by the proposed analysis may con firm or modify current expectations of the magnitude of risk and the behavior of cash flows. If risk is substantially less than as sumed, or defenses against an adverse cash position are revealed, then reduction of liquidity and flexibility may be appropriate. CHAPTER VII CONCLUSIONS Providing a systematic operational approach to risk measure ment of long-term debt in industrial companies employing convertible subordinated debentures is the objective of this study. Of seventeen financial managers interviewed, all evaluate the choice between long-term debt and equity in the capital structure on the basis of five factors. These are: suitability, profitability, risk, flexibility, and timing. Suitability refers to the compatibility of the types of funds used in relation to the nature of the assets financed. The degree of profitability in a capital structure refers to the change in earnings per share resulting from employing alterna tive methods of financing. Flexibility refers to the financial man ager's ability to adjust his sources of funds up or down in response to major changes in the needs for funds. Timing of financial policy relates to the changes in the cost and availability of alternative sources of funds at various periods during the "life-financing-cycle" of a business firm. The financial literature indicates that greater progress has been made in the appraisal of suitability, profitability, flexibility, and timing than in that of risk. Generally, risk denotes the possibility of occurrence of an adverse event or effect. With respect to long-term debt, risk is the probability of adverse effects resulting from a commitment to make 134 135 cash payments, certain In amount and timing, under uncertain future financial circumstances. These adverse effects may range from a modest increase in the emotional strain of management to the event of bank ruptcy. They include such considerations as negative income effects and interference with flexibility in future financing. In order to examine risk-of-debt in a simple and familiar frame work, this study focuses on the limits of adversity, that is, the pos sibility that all outstanding and contemplated long-term debt could result in cash insolvency. This oversimplification is justifiable because businessmen commonly evaluate debt limits in terms of this ultimate hazard. Risk-of-debt financing is characterized by an attempt to balance the amount and timing of total cash inflows and outflows. Viewed in this manner, any measurement of the risk-of-debt begins with an ap praisal of expected variations in total cash inflow and of management's influence over total cash outflows. Management can then ascertain the extent to which the probability of cash insolvency is increased by the issuance of long-term debt. This chapter is divided into two parts. The first part is a summary of business practice with respect to convertible subordinated debentures. The second part is a summary of the problems involved in the measurement of the risk of senior and subordinated debt and the writer1s recommendations. 136 Convertible Subordinated Debentures In the appraisal of the profitability aspect of the choice be tween debt and equity, financial managers employed four quantitative measures of performance: earnings per share, dividends per share, market price and price earnings ratio of the common stock. Manage ment's responsibilities to shareholders were believed to be fulfilled if the absolute values of any of these criteria increased. These four standards demonstrated that internally generated funds were more beneficial to per share performance than equity issues or debt. There fore, financial managers of the companies in the sample favored internal generation as the primary source of new funds; senior debt was ranked second, followed by convertible subordinated debentures, common stock and preferred stock: This became the order of priority of the sources • 4 ■ of funds for the companies interviewed. In the utilization of these m sources of funds, according to the priority listed above, senior debt and internally generated funds were to be employed on a continuous and permanent basis. Convertible subordinated debentures were to be employed on a temporary basis. In those companies in which needs exceeded internal generation, and senior debt capacity had been employed to the maximum, management considered either convertible subordinated debentures or common stock. Issuance of either type of security broadened the borrowing base and permitted the sale of additional senior debt securities. Under such circumstances convertible subordinated debentures offered the dual 137 I advantages of being temporary and of permitting the most favorable pricing of common stock (when ultimately converted). In this regard, convertible subordinated debentures provided for the unavoidable peaking of fund requirements in excess of internally generated funds. Leveraging the earnings on conmon equity was a secondary inducement to the employment of convertible subordinated debentures. Because of a desire for reliance on internal funds, convertible subordinated debentures were regarded as a temporary component of the capital struc ture, to be replaced by future generation of internal funds or con version into conmon stock. While aware of the advantages of convertible subordinated debentures, financial managers were fearful of the amount of debt servicing risk that accompanied the issuance of convertible sub ordinated debentures. The measurement of this risk of cash insolvency resulting from the assumption of additional debt servicing charges be came the objective of every financial manager and the primary purpose of this dissertation. Measurement of the Risk of Senior and Subordinated Debt In the formulation of managerial rules to measure the risk of senior and subordinated debt, financial managers relied on the recom mendations of investing institutions (predominately life insurance companies) indirectly received through financial intermediaries (in vestment bankers) and the practices of companies in similar industries. 138 Borrowers in the sample were unable to formulate a workable future risk-of-debt policy based upon the investment banker's decision to underwrite a new issue of debt. In addition, financial managers were unable to formulate an individual company risk policy on the basis of a historical comparison between two or more companies in a similar industry. The borrowing risk rules employed by financial managers of the companies in the sample were examined and evaluated. For purposes of this study, the borrowing rules were classified as internal and ex ternal. The internal borrowing rules, formulated from sources within the company, were of a quantitative nature. They were: (a) long term debt as a percentage of net tangible assets^ (utilizing the company's balance sheet) and (b) earnings coverage (utilizing the company's income statement). If a proposed debt issue satisfied the predetermined borrowing rules it was accepted, otherwise, it was re jected. The external borrowing rules, formulated from sources outside the company, were: (a) a predetermined interest rate ceiling (uti lizing long term "AAA" rates as a standard) and (b) a minimum bond rating on new debt financing (utilizing the evaluation of the bond rating agencies as a standard). If the debt, issue was within these borrowing standards, it was accepted. If not, it was rejected. Net tangible assets as employed by the financial managers interviewed is the difference between total tangible assets and total current liabilities. 139 The conventional borrowing rules for measuring the risk-of debt, employed by all the companies in the sample, were interpreted as though specific amounts of senior debt were presumably "safe" to assume and any amount of subordinated debentures above this level threatened solvency. However, the nature of these decision rules rendered any formulation of the specific amount of debt which is "safe" to assume virtually impossible. Such management concepts of the appropriate borrowing limits were deficient guides to an individual company debt policy. The rules employed did not adequately inform the financial manager of the probability of cash insolvency. The borrowing rules failed to consider individual cash flow characteristics and risk preferences. Therefore, a method of examining the risk of cash in solvency in industrial companies employing convertible subordinated debentures by analyzing those elements significantly affecting varia tions in cash flows was formulated. A practical alternative approach to conventional decision standards was thereby provided. Chapter VI was devoted partially to the development of a valid conceptual structure for measuring the risk of cash insolvency arising from the issuance of debt securities and, in particular, convertible subordinated debentures. Because any theoretical application was restricted by the level of abstraction required, an operational ap proach to borrower risk in industrial companies employing convertible subordinated debentures was formulated. Furthermore, a method of re shaping current data and judgments to conform to a predetermined frame work was proposed. The result was an analysis of the simulated adverse 140 limits of cash flows which measured the risk of cash insolvency and indicated the impact of debt servicing on risk for industrial com panies employing convertible subordinated debentures. Though theoretically plausible, this approach is not intended as a substitute for the risk decision standards presently employed by companies in the sample. Anyone undertaking such an analysis is en couraged to examine the debt policies of comparable businesses and the risk standards set by investors. Management must seek the coun sel of experts in the capital market but need not depend solely on external opinion. Upon reviewing Chapter VI, two financial executives of aero space companies in the sample were disinclined to alter their approach to risk. A natural reluctance to move from traditional rules to an involved analysis may be an inhibiting factor. However, the use of simpler rules merely camouflage the problem's complexity. In the interest of better decision-making, a more precise definition of the problem of risk measurement of long-term debt must be formulated. Two reasons are advanced by the writer for the utilization of the simulated cash flows method for evaluating borrower risk in in dustrial companies employing convertible subordinated debentures. First, the analysis can be completed at various levels of refinement and the results interpreted in conjunction with conventional borrower risk criteria. Second, all financial managers in the sample recognize that the amount of risk and debt acceptable to an investor varies with in a negotiable range. The only absolutely certain method for actually 141 determining a firm's desired position within this range Is an analysis of cash flows. Conventional methods presently employed by financial managers are merely approximations of the amount of borrowing risk in industrial companies employing convertible subordinated debentures. The same two financial managers in the aerospace industry, who were disinclined to alter their approach to risk, believed that bor rower determination of risk-bearing capacity in industrial firms em ploying convertible subordinated debentures was an academic exercise. For these managements, the company risk posture was defined primarily by the investor. The borrower had deliberately chosen to operate with in predetermined investor debt limits because any departure from con ventional standards might be penalized by a lower credit rating or a depressed market price for common stock. However, since the market's standards of debt capacity provide a range of acceptable behavior, management need only position itself within that range to maximum advantage. Improved information concerning borrower risk associated with senior and subordinated debt implies a more intelligent response to practical market considerations. After reading Chapter VI, four of seventeen financial managers, two in aerospace and two in petroleum refining, criticized cash flow analysis because they thought that time might modify the applicability of a borrower risk policy so derived. Though imperceptible, change did occur in the limits of variation of the determinants of cash flow. Subsequently, a periodic reconsideration of the assumptions underlying 142 cash flow analysis was required. Thus, the validity of earlier judg ments was subject to re-appraisal. In conclusion, the writer's research findings relating to con vertible subordinated debentures and the proposed analytical approach to borrower risk in industrial companies employing convertible sub ordinated debentures are restated in the form of six axioms: (1) Risk decision rules employed by financial managers in the sample implied a concern for events with a remote probability of occurrence. This evidence conflicted with management's attitude to ward borrower risk of convertible subordinated debentures as the ac cepted debt limits were approached. Either the borrower risk of con vertible subordinated debenture financing was over-estimated or a conservative risk policy was pursued. Assuming the latter, the aggressive assumption of the risks of new product development, ex pansion of markets and inventory accumulation were inconsistent with existing debt policy. Misjudgment may have been present. (2) When the risk of cash insolvency was remote, financial managers became concerned with a temporary cessation of discretionary expenditures for dividends, research and capital investments. When the nature of borrower risk of convertible subordinated debentures was identified, management's disposition to assume debt and discre tionary expenditures was altered, particularly when an adverse event possessed a remote probability of occurrence. (3) Major differences in the cash flow patterns of industrial companies illustrated the need for an approach to borrower risk policy 143 which considered individual company characteristics and risk pref erences. (4) Institutional investor risk standards were inappropriate as an operating guide to borrower risk policy in industrial companies employing convertible subordinated debentures. Such standards in sured safety only for mature, profitable and relatively stable com panies . (5) The importance of cash flows demonstrated the inadequacy of balance sheet or income statement risk standards as a basis for borrower risk policy decisions in industrial companies employing convertible subordinated debentures. (6) The effect of changes in the amount of senior and sub ordinated debt outstanding were of less importance to the continued solvency of the business firm than the effect of variations in man agement policies and practices relating to new product development, inventory accumulation and market expansion. BIBLIOGRAPHY Books Bierman, Harold, Jr. and Smidt, Seymour. The Capital Budgeting De cision. New York: Macmillan, 1960. Bellemore, Douglas H. Investment Principles, Practices and Analysis. 2nd ed. New York: Simmons-Boardman Publishing Corp., 1960. Chatterton, Robert W. Subordination of Debt by Agreement. Honolulu: Paradise of the Pacific, Ltd., 1956. Cyert, Richard M. and March, James G. A Behavioral Theory of the Firm. Englewood Cliffs; New Jersey: Prentice-Hall, Inc., 1963. Dean, Joel. Capital Budgeting. New York: Columbia University Press, 1951. Dewing, Arthur Stone. The Financial Policies of Corporations. 2 vols. 5th ed. New York: The Ronald Press Company, 1953. Donaldson, Elvin F. Corporate Finance, New York: The Ronald Press Company, 1957. Donaldson, Elvin F. and Pfahl, John K. Corporate Finance. 2nd ed. New York: The Ronald Press Company, 1963. Donaldson, Gordon. Corporate Debt Capacity. Boston, Mass.: Grad uate School of Business Administration, Harvard University, 1961. Floyd, Joe S. and Hodges, Luther H., Jr. Financing Industrial Growth: Private and Public Sources of Long Term Capital for Industry. Chapel Hill, North Carolina: School of Business Administration, University of North Carolina, 1962. Foster, Louis.0. Corporate Debt and the Stockholder: The Effects of Borrowing on Rates of Return. Hanover, New Hampshire: Amos Tuck School of Business, Dartmouth College, 1956. Gerstenberg, Charles W. Financial Organization and Management of Business. 4th ed. Englewood Cliffs, New Jersey: Prentice- Hall,. Inc., 1959. 144 145 Gordon, Myron J. The Investment, Financing and Valuation of the Corporation. Homewood, Illinois: Richard D. Irwin, Inc., 1962. Graham, Benjamin, Dodd, David L., Cottle, Sidney and Tatham, Charles. Security Analysis. 4th ed. New York: McGraw-Hill Book Company, 1962. Gray, j. Seton. Common Sense in Business. New York: McGraw-Hill Book Company, 1956. Grayson, C. Jackson, Jr. Decisions Under Uncertainty. Boston, Mass.: Graduate School of Business Administration, Harvard University, 1960. Guthmanp, Harry G. and Dougall, Herbert E. Corporate Financial Pol icy . 4th ed. Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1962. Haavelmo, Tryve. A Study in Investment Theory. Chicago, Illinois:' University of Chicago Press, 1960. Hart, Albert Gailord. Anticipations, Uncertainty and Dynamic Plan ning . New York: Augustus M. Kelley, Inc., 1951. Istvan, Donald F. Capita1-Expenditure Decisions: How They Are Made in Large Corporations. Bloomington, Indiana; Bureau of Business Research, Graduate School of Business, Indiana University, 1961. Johnson, Robert W. Financial Management. 2nd ed. Boston: Allyn and Bacon, Inc., 1962. Knight, Frank H. Risk, Uncertainty and Profit. Boston: Houghton- Mifflin Company, 1921. Lutz, Friedrick and Vera. The Theory of Investment of the Firm. Princeton, New Jersey: Princeton University Press, 1961. McDonald, John Dennis. Strategy in Poker, Business and War. New York: W. W. Norton & Company, 1950. Masse, Pierre. Optional Investment Decisions: Rules for Action and Criteria for Choice. Englewood Cliffs, New Jersey: Prentice- Hall, Inc., 1962. Meyer, John R. and Kuh, Edwin. The Investment Decision: An Empiri cal Study. Cambridge, Mass.: Harvard University Press, 1957. 146 Pilcher, C. James. Raising Capital with Convertible Securities. AmArbor, Michigan: Bureau of Business Research,.School of Business, University of Michigan, 1955. Poston, Charles F. Restricted Stock Options for Management. Chapel Hill, North Carolina: School of Business Administration, University of North Carolina, 1960. Solomon, Ezra (ed.). Management of Corporate Capital. Glencoe, Illinois: The Free Press of Glencoe, Illinois, 1959. Periodicals Alchian, Armen A. "Uncertainty, Evolution and Economic Theory," The Journal of Political Economy, LVIII (June, 1950) , 211-2 2 1 . Allen, Ferry B. "Does Going Into Debt Lower the Cost of Capital?" The Financial Analysts Journal, X (August, 1954), 57-61. Bernoulli, Dominic. "Exposition of a New Theory on the Measurement of Risk," Econometrica, XXII (January, 1954), 23-36. Billick, Stanley R. "Subordination--A Problem in Semantics," Time Sales Financing. XX (June-July, 1956), 3-7. Browman, Keith L. "The Use of Convertible Subordinated Debentures by Industrial Firms, 1949-1959," The Quarterly Review of Economics and Business, III (Spring, 1963), 67-75. Campbell, E. Douglas. "Financial Planning for Future Growth," Consumer Finance News, XLVI (December, 1961), 3-5. Childs, John F. "Convertible Debentures as a Medium of Financing," Public Utilities Fortnightly. XLI (March 1, 1948), 333-343. Coleman, Almand R. "Funds Statements and Cash Flow," The Controller, XXIX (December, 1961), 592-595. "Corporate Financing Directory," Investment Dealers' Digest, (1950- 1963). Cyert, R.M.; Simon, H. A. and Trow, D. B. "Observation of a Busi ness Decision," The Journal of Business. XXIX (October, 1956), 237-248. Dean, Joel. "An Approach to Internal Profit Measurement," The N.A.A. Bulletin, XXXIX (March, 1958), 5-12. 147 ______. "Measuring the Productivity of Capital," Harvard ’ Business Review, XXXII (January-February, 1954), 120-130. Dobrovolsky, S. P. "Economics of Corporate Internal and External Financing," The Journal of Finance. XIII (March; 1958), 35-47. Donaldson, Gordon. "Financial Goals: Management vs. Stockholders," Harvard Business Review, XLI (May-June, 1963), 117-123. '______. "In Defense of Preferred Stock," Harvard Business Review, XL (July-August, 1962), 129-136. ______. "New Framework for Corporate Debt Policy," Harvard Business Review, XL (March-April, 1962), 117-131. Egerton, R. A. D. "Investment, Uncertainty and Expectations," Review of Economic Studies, XXII (No. 2, 1955), 143-150. Fisher, Lawrence. "Determinants of Risk Premiums on Corporate Bonds," The Journal of Political Economy, LXVII (June, 1959), 217-237. Fleischer, Arthur, Jr. and Gary, W. L. "The Taxation of Convertible Bonds and Stocks," Harvard Law'Review, LXXIV (January, 1961), 473-524. Gelvin, L. M. "Return on Investment Concept and Corporate Policy," The N.A.A. Bulletin. XLII (July, 1961), 37-49. Guthmann, Harry G. "Dilution and Common Stock Financing," Harvard Business Review, XXIII (Winter, 1944), 246-252. ______. "Measuring the Dilution Effect of Convertible Secur ities," The Journal of Business, XI (January, 1938), 44-50. Hanf, Arthur H. "Financing Via Long-Term Debt," The Industrial Banker, XXVII (October, 1961), 15-16, 21-22. Johnson, Ted W. "Growth Companies - Problems and Sources of Funds," Robert Morris Associates Bulletin, XXXIX (April, 1957), 223. Johnson, Robert W. "Subordinated Debentures: Debt that Serves as Equity," The Journal of Finance, X (March, 1955), 1-16. Kalecki, Michael. "The Principle of Increasing Risk," Economica, IV (November, 1937), 440-447. _____ . "A Comment on the Principle of Increasing Risk: A Reply." Economica, V (November, 1938), 459-460. 148 Kraemer, M. T. "Advantages of High Debt and Preferred Stock Finan cing," Publi£ UtiAitiejs For^nigh_tl^, LXII (November 20, 1958), 875-885. Latane, Henry A. "Criteria for Choice Among Risky Ventures," The Journal of Political Economy, LXVII (April, 1959), 144-155. Liebling, Henry I. "Financing the Expansion of Business," Survey of Current Business, XXXVII (September, 1957), 6-14. Livingston, William G. and Brown, Robert C. "Why Measure Return on Capital?" The N.A.A. Bulletin. XLII (September, 1961), 17-26. Mason, Perry. "Cash Flow Analysis and Funds Statements," The Journal of Accountancy, CXI (March, 1961), 59-72. Miller, Donald C. "Corporation Taxation and Methods of Corporation Financing," American Economic Review, XLII (December, 1952), 839-854. Miller; John H. "A Glimpse at Practice in Calculating and Using Re turn on Investment," The N.A.A. Bulletin, XLI (June, 1960), 65-76. Miller, Stanley R. "Increased Usage of Convertible and Subordinated Issues," The Commercial and Financial Chronicle. CLXXVI (Nov ember 20, 1952), 3, 40-41. Paul, Frank J. "Analysis of the Banker's Position with Respect to Subordinated Long-Term Debt," Robert Morris Associates Bulle tin. XXX (May, 1948), 437-444. Pilcher, C. James. "Convertibles - Senior Securities or Common," Michigan Business Review, X (January, 1958), 22-25. Santow, Leonard J. "Ultimate Demise of Preferred Stock as a Source of Corporate Capital," The Financial Analysts Journal, XVIII (May, 1962), 47-54. Sauvain, Harry C. -"Has Business Borrowed Too Much?" Business Hori zons , I (Winter, 1958), 48-65. Scanlon, James J. "Trends in Corporate Finance," Public Utilities Fortnightly. LXXI (March 28, 1963), 15-27. Schwartz, Eli. "Theory of the Capital Structure of the Firm," The Journal of Finance, XIV (March, 1959), 18-39. Silberman, Charles E. "How Much Can Business Borrow?" Fortune, LIV (June, 1956), 131-135. 149 Simon, Henry A. "Theories of Decision-Making in Economics and Behav ioral Science," American Economic Review. XLIX (June, 1959), 253-283. Smith, Dan T. "Corporate Taxation and Common Stock Financing," National Tax Journal, VI (September, 1953), 209-225. Thompson, G. Clark and Walsh, Francis J. Jr. "Companies Stress Div idend Consistency," Management Record, XXV (January, 1963), 30-36. Walter, James E . "A Discriminant Function for Earnings - Price Ratios of Large Industrial Corporations," Review of Economics and Statistics, XLI (February, 1959), 44-53. ______. "Determination of Technical Solvency," The Journal of Business, XXX (January, 1957), 30-43. •______. "Dividend Policies and Common Stock Prices," The Journal of Finance, XI (March, 1956), 29-41. ______. "Liquidity and Corporate Spending," The Journal of Finance, VIII (December, 1953), 369-387. ______. "The Use of Borrowed Funds," The Journal of Business, XXVIII (April, 1955), 138-147. Wellisz, Stanley. "Entrepreneur's Risk, Lender's Risk and Invest ment," Review of Economic Studies. XX (No. 2, 1953), 105-115. Weston, J. Fred. "Norms for Debt Levels," The Journal of Finance, IX (May, 1954), 124-135. ______. "The Timing of Financial Policy," The Controller, XXIX (December, 1961), 596-600, 624. Winn, Willis J., and Hess, Arleigh. "The Value of the Call Privilege," The Journal of Finance. XIV (May, 1959), 182-196. Zimmerman, Chester G. "Loans to Closed Corporations Having Subordin ated Debt Versus Those Having Only Bona Fide Equity Capital," Bulletin of Robert Morris Associates. XLI (May, 1959), 17-27. Government Publications U. S. Securities and Exchange Commission. Cost of Flotation of Corporate Securities. 1951-1955. Washington, D. C.: United States Government Printing Office, June, 1957. 150 Publications of Professional, Educational and Other Organizations A Case Study of Management, Planning and Control at General Electric Company. New York: Controllership Foundation, Inc., 1955. Evans, George Heberton, Jr. "Discussion: The Development of Histori cal Series on Sources and Uses of Corporate Funds," Conference oh Research in Business Finance. New York: National Bureau of Economic Research, Inc., 1952. Financial Planning for Greater Profits. Management Report No. 44. New York: American Management Association, 1960. How H. J. Heinz Manages Its Financial Planning and Controls. New York: American Management Association, 1963. Jacoby, Neil H. and Weston, J. Fred. "Factors Influencing Material Decisions in Determining Forms of Business Financing: An Ex ploratory Study,". Conference on Research in Business Finance. New York: National Bureau of Economic Research, 1952. Management Planning and Controls: The H. J. Heinz Approach. New York; The Controllership Foundation, 1957. A Program of Financial Planning and Controls: The Monsanto Chemical Company. Financial Management Series No. 102. New York: American Management Association, 1953. Return on Capital as a_ Guide to Managerial Decisions. Research Report No. 35. New York: National Association of Account ants, 1959. Unpublished Materials Ang, Henry Suihun. A Study of Financial Expansion in the Basic Chemical Industry, 1947-1956. Ph.D. dissertation, University of Illinois, 1961. Benishay, Haskell. Determinants of Variability in Earnings Price Ratio of Corporate Equity. Ph.D. dissertation, University of Chicago, 1960. Fetzer, Joseph B. An Analysis of Long-Term Financing Policies of United States Oil Companies. Ph.D. dissertation, Stanford University, 1963. Usher, Dan. The Debt Equity Ratio. Ph.D. dissertation, University of Chicago, 1960.