CAPITAL STRUCTURE AND DIVIDEND PAYOUTS

The board of directors of Baldwin Inc. met today to discuss thecapital structureanddividend policyof the company. The board discussed the optimal capital structure of 60 percent debt and 40 percent equity and the likely effect of the capital structure on the company's weighted average cost of capital (WACC) and the firm value. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Therefore, the debt ratio of 60 percent was considered acceptable. However, Gregg, the CFO of the company, stressed that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter the profit of the company. He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Gregg continued to explain that if the company files for bankruptcy there aredirect and indirect coststhat Baldwin must incur.

Mr. Milosvoski, a board member suggested that there are ways to reduce the cost of debt by hiring an expert to handle the company's debt agreements between the shareholders and bondholders. He stated thatprotective covenantsare incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. He mentionednegative covenantand apositive covenantas types of protective covenants the company should take seriously.

John Miller, another board member stated that one reason bankruptcy costs are so high is that different creditors and their lawyers contend with each other. He suggested that if debt can be consolidated, or if bondholders can be allowed to purchase stock of the company bankruptcy cost will be reduced. In this way, stockholders and debtholders are not pitted against each other because they are not separate entities. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money.

The employee representative on the board, Ms. Johnson used thefree cash flow hypothesisto state that firms with high free cash flow are very likely to undertake more wasteful activity which has a serious implication for capital structure. Since dividends leave the firm, they reduce free cash flow. Thus, according to her, an increase in dividends should benefit the stockholders by reducing the ability of corporate managers to pursue wasteful activities. She continued that since interest and principal also leave the firm, debt can reduce free cash flow and wasteful spending. But because corporate managers are not legally obligated to pay dividends, she suggested that debt of the company be increased.

Philip Suzuki, director of Public Relations and a board member was of the view that determining optimal debt-equity ratio is not an easy task and varies across industries so Baldwin should follow the rules of thepecking-order theorywhen financing capital projects.No agreement was reached on the company's capital structure, but the CEO and Gregg believed that the 60-40 debt-equity capital structure will minimize the cost of capital and improve the firm value.

The board is retaining you as the financial consultant to assist with the company's capital structure and dividend payout decisions. The Chairman of the board wants you to address the following questions:

1. List 5 reasons tosupportMs. Johnson'sfree cash flow hypothesisclaim that debt of Baldwin Inc. be increased. The reasons you give should focus on advantages of debt that can convince the board to increase the debt-to equity ratio of the company.

2. State 5 examples of direct and indirect costs associated withbankruptcythat Gregg stated in his presentation to the board.

3. Give two examples each ofpositive covenantandnegative covenantas stated by Mr. Milosvoski in his protective covenant explanation.