FIN.11:5 - Archetypal Grounding

A constructed corporation needs 100 for the same assets. Mix A provides debt 80 and equity 20 with annual debt service 35; mix B provides debt 40 and equity 60 with service 15. Assume these are obtainable terms without other cash cost. Cash available before debt service is 60 in the base state and 25 in the adverse state, and the corporation requires at least 5 remaining cash. A leaves 25 in the base state but −10 in the adverse state. B leaves 45 and 10. B satisfies the stated cash requirement in both states; A does not. This establishes a capacity constraint, not that B is universally optimal: the additional equity’s price, control effects and other feasible terms remain part of the choice.

FIN.11:5.1 - More interest tax savings need not mean a better policy

In a separate constructed comparison, an unlevered operating value of 200 is supplied on grounds that exclude the financing effects below. The alternatives are no debt, principal 40 for two years with annual interest 6%, or principal 80 for two years with annual interest 10%. The stated terms are obtainable. Both debts repay principal at the end of year 2; their service capacity is tested separately. The only tax effect is a fully usable 25% deduction for interest paid at each year end. A qualified 5% rate applies to these stipulated tax-saving cash flows; it is not inferred from either loan’s coupon.

The 40 loan pays interest 2.4 each year and saves tax 0.6 each year, so the saving’s present value is 0.6/1.05 + 0.6/1.05² = 1.12. The 80 loan pays interest 8 and saves tax 2 each year, worth 3.72 on the same stated basis. Nonoverlapping estimates put financing-induced operating and distress losses at present values 0.2 and 5 respectively; issue costs paid now are 0.2 and 0.5. These loss estimates are supplied case inputs, not universal percentages of debt.

The smaller debt has the highest value among these alternatives on the supplied grounds. If it fails the separate dated service or consent conditions, that does not make it available merely because its value is highest. If the larger policy’s additional loss falls below about 2.50, with all other grounds retained, its value exceeds the smaller policy’s value. That threshold identifies the consequential disputed estimate; extra decimal precision in the debt ratio would not settle it.

This comparison is of total value before allocation to claims. Deriving old owners’ wealth after an issue, repayment or payout requires the actual proceeds and ownership treatment. Subtracting all new principal as an additional resource loss here would misrepresent the borrowing; ignoring its claim when subsequently deriving equity value would be the opposite error.

FIN.11:5.2 - Turn a capital target into a recapitalization

Consider a separate corporation with debt worth 60 and ordinary equity worth 140. A qualified valuation of a proposed financing policy gives 220 for the claims remaining after its recapitalization and distribution. That value includes retained cash and the net policy effects, using FIN.5’s pricing grounds and FIN.7’s value and claim boundary; it is not inferred from the desired debt ratio. All debt is priced at par before and after, there are no other claims or fees, and the contractual and distribution conditions permit the transaction.

The chosen one-time target is debt at 40% of post-transaction debt-plus-equity value. Hence target debt is 0.40 × 220 = 88 and remaining equity is 132. Keep the existing debt 60 and obtain 28 of additional net borrowing for a cash distribution of 28 to the existing owners. Their retained equity 132 plus received cash 28 is worth 160, compared with their earlier 140. The supplied net policy gain is 20; the distribution itself transfers cash out of the corporation rather than creating another gain of 28.

Holding the old equity value fixed would give D/(D + 140) = 0.40 and D = 93.33, implying combined claims of 233.33 instead of the supported 220. That calculation mixes the old equity with the new financing. A different proposed debt amount needs a valuation consistent with its own policy; it cannot inherit the preferred answer by retaining an old denominator.

The company has cash 10 and must preserve a reserve of 10 through closing. The available loan must deliver its 28 before the distribution: cash then moves from 10 to 38 and back to 10. If loan settlement follows the proposed distribution date, paying 28 would leave −18 and the transaction is not presently funded. Move the distribution, obtain an earlier arrangement or revise the plan. Return future service and all affected restrictions to FIN.2 and FIN.12 as well.

This calculates one recapitalization on its stated value and terms. Maintaining a 40% ratio as later market values change would be a repeated rebalancing policy with new transactions, cash requirements and pricing grounds; it is not an automatic consequence of this closing calculation.