Corporate Financial Policy

A corporation's financial policy defines the company's overall approach to managing its financial decisions. A company's financial strategy is comprised of the following: Capital budgeting, financing and dividend policy. While every corporation typically deals with these three areas when setting its financial policies, each organization must examine many factors that are unique to its business and situation before setting up its overall policies. Trends in setting corporate financial policies have been changing over the past decade. While investors and shareholders want to insure that there is capital available to grow the business, shareholders are increasingly comfortable in accumulating debt to do so. In today's fast changing marketplace, corporate managers and investors are looking for short-term gains as opposed to more traditional long-term financial strategies. The financial fitness of an organization is typically assessed from looking at its balance sheet; the ways that companies are willing to manipulate or dirty their balance sheets is discussed. Investors are keen to see a return on their equity investment in the form of dividends (also known as shareholder or investor value). Investors and shareholders have become increasingly active in determining corporate fiscal policy with an eye toward short-term financial rewards for themselves. U.S. corporations and their investors are much more comfortable operating at much higher risk levels than ever before; U.S. corporations have on average the lowest credit rating in history which is another indication of how comfortable today's corporations are at operating in high risk situations.

There are many aspects associated with planning and implementing a corporate financial policy. Historically, corporations have focused on both short-term and long-term planning when determining financial policies. Conventional wisdom indicates that investors favor companies with good fundamentals or a strong balance sheet. Corporations are faced with many decisions related to how to grow and finance their operations. The following are some factors that companies typically take into account when mapping out their financial strategy:

• Since the interest on debt is deductible, does it make sense to borrow more?
• What is the best thing to do with excess cash?
• Should cash be used to finance the business or returned to shareholders?

While these questions are rhetorical in nature, the answers are really dependent upon linking financial strategy and business strategy. In terms of solid planning, companies should be looking into the longer term (typically 3-5 years) for direction. In essence, companies should have solid projections about what their cash flow or debt service will be for the next few years. If cash flow is strong, then companies are in a good position to acquire target companies in their industry, fund capital projects, or even improve existing operations. Cash allows companies much flexibility and security. Some mature companies may not have any acquisition targets and may well decide to distribute cash back to investors or shareholders. A couple of options are buying back stocks that are undervalued or paying dividends with them if they are overvalued (Godehart, Koller & Rehm, 2006). Companies that are less mature or in highly competitive markets may have no choice but to take on debt to stay competitive -- investments in infrastructure or target acquisitions are necessary to capture market share. A company's credit rating has historically been an important factor in securing competitive rates for borrowing. This essay discusses the changing trends in credit ratings in the U.S. and how these changes are affecting corporations. Debt is certainly not all bad, and many companies benefit from interest deductions on debt. Debt also keeps many companies honest by requiring discipline in making interest and principal payments.

Public corporations have long answered to shareholders by developing and executing solid financial policies. Much has been written about federal legislation that has been enacted to safeguard investor equity in corporations. Increasing numbers of public companies are "going private" as a way to escape the demanding regulatory environments imposed by federal legislation. This essay looks at the impact that private equity funds have had in the "going private" movement and the effects that this trend has on corporate financial policy. Investors in public companies have become more involved in setting social and financial policies at their organizations. These so-called activist investors are shaping capital structures by influencing the debt-to-equity ratios of their companies. Finally, this essay looks at the high tolerance for risk that became prevalent in Corporate America in the early 2000s. Access to cheap and abundant capital, emboldened shareholders and investors, and a high tolerance for risk have truly had a profound effect of corporate financial strategies.

Applications

Investors typically look at a company's balance sheet as an indication of financial fitness. The company balance sheet illustrates the capital structure of an organization. Capital structure is a term that deals specifically with a company's debt-to-equity ratio. The ratio of debt to equity has always been an important consideration for investors and offers one of the best pictures of a company's leverage.

Managing capital structure is a balancing act that requires financial flexibility and fiscal discipline. Achieving a balance of debt and equity has been one of the biggest challenges to organizations, and it remains a big challenge. The long-term impact of capital structure means managing operating cash flows and cost of capital. The interest exposure on debt is tax deductible, and a company can reduce its after-tax cost of capital by increasing debt relative to equity (Godehart, Koller & Rehm, 2006).

Calculating Debt-to-Equity

Total Liabilities / Total Shareholders' Equity,

where shareholder equity = common stock plus firm profits or losses

(Adapted from McClure, n.d.)

The following is an illustration of the impact that the debt-to-equity ratio can have on an organization. In general, a debt ratio of 0.5 to 1.5 is considered to be a good ratio (McClure, n.d.).

If Company A has long-term debt (in a bond) of $10 million and has $10 million in equity, the debt-to-equity ratio is 1 (10 / 10 = 1). This ratio falls well within acceptable debt-to-equity ratios.

If Company B has long-term debt (in a bond) of $10 million and has $1 million in equity, the debt-to-equity ratio is 10 (10 / 1 = 10). This ratio is way too high for most investors to feel comfortable. This company is debt laden.

It Company C has long-term debt (in a bond) of $10 million and has $20 million in equity, the debt-to-equity ratio is 0.5 (10 / 20 = 0.5). This ratio will be looked upon favorably by investors because the company has little debt compared to its equity.

Balancing Debt & Equity

"Indeed, the potential harm to a company's operations and business strategy from a bad capital structure is greater than the potential benefits from tax and financial leverage. Instead of relying on capital structure to create value on its own, companies should try to make it work hand in hand with their business strategy, by striking a balance between the discipline and tax savings that debt can deliver and the greater flexibility of equity" (Godehart, Koller & Rehm, 2006).

Strong corporate fundamentals are a requisite for investors. Investors have longed used criteria such as solid balance sheets and favorable credit ratings to decide where to invest their dollars. But just how much faith investors can put into balance sheets is being questioned. Baldwin describes tactics that create "dirty balance sheets." He describes tactics that reward companies to pile on debt by perpetuating the practice of allowing corporate deductions on interest from debt. "Financial engineers replace equity with debt and therefore cut tax bills" (Baldwin, 2006).

According to Baldwin, there are a couple of popular ways to turn equity into debt and spin the whole process as a being a sound financial strategy. The first way is to have a debt-financed takeover. This popular strategy allowed private equity firms to finance takeovers and buyouts with little money down and a reward in the form of an interest deduction on the huge debt. The second option for turning equity to debt involves the practice of companies buying back their own stock (shares), which shrinks their equity and their tax bills. The trend toward dirtying up balance sheets happened on a grand scale in the early-to-mid 2000s (Baldwin, 2006). There was a significant trend toward dirtying or repackaging existing corporate debt-to equity figures (as well as buying and reselling of existing corporate stocks).

"This dirtying-up of corporate balance sheets [was] taking place on a grand scale. The graph below shows how much the retirement of equity (via buybacks, LBOs and merger activity) exceed[ed] the issuance of equity (through offerings of new shares)" (Baldwin, 2006, p.18).

Issues

Corporate Credit Ratings

According to a January 2006 Deutsche Bank Survey, respondents stated that the single most important factor in a firm's decision regarding overall capital structure was the credit rating of their company. In 2001, another survey had credit ratings as the second most important factor in determining capital structure. There are a number of reasons why credit ratings are watched closely by companies. Factors include:

• Rate changes on debt -- a downgrade makes debt a lot more expensive to finance;
• Lower credit ratings result in diminished access to capital markets;
• Companies with lower ratings do not have access to debt capital as quickly (readily) as companies with higher credit ratings; and
• A lower credit rating reflects the likelihood of financial distress -- a downgraded credit rating indicates a question about a company's ability to make its principal and interest payments.

Generally speaking, credit rating agencies look at short-term and long-term debt on a company's balance sheet in determining debt -- even though there may be other debt on the books. Overall, the survey indicates that companies and managers consider credit rating to be a key determinant in how much debt they should have (Servaes & Tufano, 2006).

In another paper that provides research on the effect of credit rating on capital structure, the author says credit rating directly affects capital structure decision making. Managers are concerned by the discrete costs (benefits) associated with rating levels. Ratings have a direct or indirect effects on the following:

• Cost of capital,
• Changes in bond coupon rates,
• Potential loss of contracts,
• Potential repurchase of bonds, and
• Loss of access to commercial paper markets.

The author points out that credit ratings are significant in every financial marketplace and thus are critical when firms consider the impact of rating changes to their organizations (Kisgen, 2006). A number of factors can contribute to a downward trend in the credit rating profile and include investor's willingness to accept higher risk and the adoption of aggressive corporate financial policies that are aimed at appeasing stockholders (Riccio, 2007).

Rating Trends

The following table illustrates the percentage changes and trends of ratings over a number of years. The percentages given show the percent of B-grade ratings by a given year; B-ratings indicated a speculative rating rather than an investment rating (A) as defined by S&P. Notice the percentage increase in speculative rated companies between 1980 and 2007 (Riccio, 2007):

Year US Industrial Companies with B-Ratings (%) 1980 7% 1988 33% 1998 36% 2007 46%

More factors contributing to the rating slump included an increase in the number of new middle market-type companies tapping the bond and loan markets and the popularity of leveraged buyouts also contributing to the amount of debt used to finance many mergers and acquisitions. Despite market analysts' predictions of a nearly inevitable, sharp increase in companies defaulting on loans, the credit markets appeared a lot more comfortable with higher credit risks in the market, and many new issuers (companies entering the public markets) seemed unfazed by the B-ratings. New entries to the market added significantly to the higher number of B-rated companies, but there was also an exodus of companies from investment grade (A) down to B-ratings. Such companies are referred to as "fallen angels" as they have slipped from investment grade to speculative grade. Further, S&P stated in 2007 that it had issued over 1,100 B-ratings in just the preceding 4 years, and even within the B-rating categories, the ratings were slipping. B+ ratings fell to a lower percentage than flat B-ratings, with B+ comprising 38% and the flat B comprising 46% (Riccio, 2007).

There is no question that companies benefited from cheap and abundant capital in the early-to-mid 2000s. Credit ratings can have a big impact on the cost of financing debt, but the rate spread between investment grade and speculative grade financing narrowed sharply. This simply means that companies with lower ratings grades have had access to equity that was quite inexpensive. A good credit rating cannot be discounted, however, as it affects decisions by investors when deciding to invest in companies. If capital becomes less readily available, it becomes more expensive for B-rated companies to finance debt and the market becomes more risk wary, then the credit rating may take back its prominent role related to debt financing.

Shareholder Value & Short-Term Earning Investment

Corporate financial policies are subject to many changes that result from economic conditions, market influences, and the influence of stakeholders. Investors in public and private companies have been playing a larger role in setting corporate financial policies.

Shareholders at public companies have only become actively involved in setting company policy since about the turn of the twenty-first century. The rise of shareholder activism apparently coincided with many of the major corporate scandals (Enron, Tyco, Worldcom) of the early 2000s. Most corporate investors did not play an active role in trying to influence management decisions and policies even though they are the true "owners" of the corporation; some estimates put the historical average percentage of dead (or un-cast) proxy votes by shareholders at 60% (Goff, 2004). The overwhelming lack of interest that these percentages show on the part of company shareholders has been blamed for corporate mismanagement on a grand scale. Shareholder activism started as a grass-roots effort to influence social policies at corporations, but later spread into the financial arena.

The easy availability of capital -- including low interest rates and low risk loans emboldened many company shareholders to pursue "shareholder value," some might say at the expense of sound corporate financial policy. According to a PriceWaterhouseCoopers (PWC) report, private equity funding has had a big impact on corporate financial decision making. Private equity (PE) funding made a big splash in corporate financial markets in the mid-2000s. PE money has been around for a while, but after 2005, its influence in the marketplace soared. Between 2005 and 2007, according to PWC, there was an increase in the collaboration between corporate managers and PE firms, which resulted in a number of high-profile public companies defecting out of public markets by "going private."

Many pundits blamed Sarbanes-Oxley's burdensome regulations with driving public companies to private status, when in fact, it may be PE that fueled the exodus. Consider the following statistics that show the percentage of "going private" deals that were funded by PE between 1998 and 2007 ("Private Equity Fuels Larger, Collaborate Going-Private Transactions," 2007):

• 1998 -- $21 billion;
• 2005 -- $63 billion;
• 2006 -- $117 billion (86% increase in 1 year);
• 2007 (1st quarter) -- $62 billion.

Additionally, beginning in 2005, there was an upsurge in larger companies "going private" ("Private Equity Fuels Larger, Collaborate Going-Private Transactions," 2007). The global economic crisis of 2008-2009 put a damper on the overall number of "going private" deals made, with the size and frequency of such deals rising again in 2010 and 2011 but cooling off again slightly in 2012 (Weil, 2013). The significance of the "going private" trend on corporate financial decisions points to an emphasis on creating shareholder value. The high returns of PE-financed deals translated into high value for both shareholders and companies. PE-financed "going private" transactions typically encourage some or all of an existing company's management team to stay onboard. Executives that do transition to private status usually take an equity share in the company -- while maintaining their managerial duties. The goal is not just to reward shareholders, but to grow the company's value and reap economic rewards for knowledgeable executives as well as the PE team. There is no question that the focus of many of these deals is on short-term growth and results, which is contradictory to many financial policies at more traditional public companies. Going private allows CEOs to escape investor scrutiny and many of the regulatory burdens that public companies must face ("Private Equity Fuels Larger, Collaborate Going-Private Transactions," 2007).

According to the Securities and Exchange Commission (SEC), "A company 'goes private' when it reduces the number of its shareholders to fewer than 300 and is no longer required to file reports with the SEC." For shareholders of public companies, the lure of high shareholder returns seen in PE going private transactions did not go unnoticed. "The latest trend for shareholders is taking on hefty debt," Kim (2007) notes. The debt accumulation will serve two purposes: Shareholders will reward themselves monetarily using other people's money, and it serves as an alternative to the acceptance of going private proposals.

"Activists have begun to clamor for companies to incur more debt, and the public increasingly embraces leveraged recapitalizations as alternatives to going-private transactions. Confident that leveraging tomorrow's cash flows to finance today's cash payments does not come at the expense of long-term prospects, companies have begun to float leveraged dividend recapitalizations in the market in order to return value to shareholders or preemptively ward off potential takeovers" (Kim, 2007, p. 6).

There is no question that many shareholders were captivated by a number of highly publicized PE deals that paid off big for investors. Investors at public companies still see high returns in PE deals as a product of financial engineering. That is to say, investors are under the impression that the promise of high returns is not necessarily dependent on investing in business operations and efficiencies. By emulating PE methods, activist shareholders are convinced that they too can reap high returns. The mantra for many public company shareholders has been as follows (Kim, 2007):

• Load up on debt;
• Sell company assets;
• Cut costs;
• Increase cash flow;
• Risk is no longer relevant;
• Debt is good, cash is bad; and
• A strong balance sheet signals weak management.

Cash flow is still critical to fund ongoing investments, research and development, and opportunities to enter new markets. Putting a stranglehold on cash and taking on massive debt still holds the great potential to choke growth. There is plenty of speculation that practices of loading up on debt lead to credit deterioration and more fallen angels.

Investor activists are certainly driving corporate financial policy to a greater extent than ever before. Highly leveraged companies do not reflect well on the company balance sheet, but investors seem oblivious. Investors have been focused on short-term gains; according to Reuters, by 2010 the average holding period for a stock on the New York Stock Exchange (NYSE) was just six months (Saft, 2012), and there has been a precipitous move away from long-term value creation.

Corporate financial policies, once careful to balance debt and equity, manage risk for shareholders and plan for the long-term growth and stability of U.S. Corporations appear subject to attention deficit.

Terms & Concepts

Activist Shareholder: An individual who tries to utilize his or her rights as a shareholder of a publicly-traded corporation to foment social change. Shareholder activism is a way in which shareholders can control a corporation's behavior by exercising their privileges as owners.

Capital Structure: "A mix of a company's long-term debt, specific short-term debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds" (Investopedia, 2007).

Debt: Debt comes in the form of bond issues or long-term notes payable.

Debt-to-Equity Ratio (D/E): "A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what portion of equity and debt the company is using to finance its assets" (Investopedia, 2007).

Equity: Classified as common stock, preferred stock, or retained earnings.

Fallen Angels: Public companies that fell from investment grade ratings to speculative grade ratings in the eyes of credit rating agencies.

Financial Engineering: "The creation of a new and improved financial products through innovative design or repackaging of existing financial instruments" (The Free Dictionary, 2007).

Going Private Transactions: A company "goes private" when it reduces the number of its shareholders to fewer than 300 and is no longer required to file reports with the SEC (SEC.gov).

Leveraged Buyouts (LBO): A highly-leveraged transaction (HLT), or "bootstrap" transaction, occurs when a financial sponsor gains a majority of control a target company's equity through the use of borrowed money or debt.

Leveraged Recapitalizations: A technique typically used to circumvent a hostile acquisition. Using this strategy, a company acquires additional debt to repurchase stocks through a buyback program or appropriates a large dividend among the shareholders.

Shareholder Value: The idea that the prioritized goal for a company is to augment the wealth of its shareholders (owners) through activities such as paying dividends and causing the stock price to rise.

Bibliography

Aslan, H., & Kumar, P. (2011). Lemons or cherries? Growth opportunities and market temptations in going public and private. Journal of Financial & Quantitative Analysis, 46(2), 489-526. Retrieved December 2, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh &AN=65931608

Baldwin, W. (2006). The equity vanishes. Forbes, 777(11), 18. Retrieved December 4, 2007, from EBSCO Online Database Academic Search Premier. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=20992864&site=ehost-live

Ben Dor, A., & Zhe, X. (2011). Fallen angels: Characteristics, performance, and implications for investors. Journal of Fixed Income, 20(4), 33-58. Retrieved December 2, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=b uh&AN=59902694

Godehart, M. Koller, T., & Rehm, W. (2006) Making capital structure support strategy. CFO.com. Retrieved December 1, 2007, from http://www.cfo.com/article.cfm/5622276

Goff, J. (2004). Who's the boss? CFO.com. Retrieved December 5, 2007, from http://ww2.cfo.com/risk-compliance/2004/09/whos-the-boss/view-all

Guo, S., Hotchkiss, E. S., & Song, W. (2011). Do buyouts (still) create value?. Journal of Finance, 66(2), 479-517. Retrieved December 2, 2013 from EBSCO online database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=59527270

Kim, J. (2007). Shareholder activists get by with a little help from a lot of leverage. Bank Loan Report, 22(15), 4-12. Retrieved December 4, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24774533&site=ehost-live

Kisgen, D. (2006). Credit ratings and capital structure. Journal of Finance. Retrieved December 4, 2007, from http://www2.bc.edu/~kisgen/Kisgen-CRCS2.pdf

Loth, R. (n.d.). Evaluating a company's capital structure. Investopedia. Retrieved December 1, 2007, from http://www.investopedia.com/articles/basics/06/capitalstructure.asp

McClure, B. (n.d.). Debt reckoning. Investopedia. Retrieved December 4, 2007, from http://www.investopedia.com/articles/fundamental/03/042303.asp

Private equity fuels larger, collaborate going-private transactions. (2007). PriceWaterhouseCoopers. Retrieved December 5, 2007, from http://www.pwc.com/us/eng/main/view6/going-private%5Ftransactions%5F40.pdf

Riccio, N. (2007, September 28). Corporate credit ratings hit a low point. Business Week Online, 25. Retrieved December 4, 2007, from Academic Search Premier database. http://search.ebscohost.com/login.aspx?direct=true&db=aph&AN=26886422&site=ehost-live

Saft, J. (2012, March 2). The wisdom of exercising patience in investing. Reuters.com. Retrieved December 2, 2013 from: http://www.reuters.com/article/2012/03/02/us-patience-saft-idUSTRE82100620120302

Servaes, H. Tufano, P. (2006). Corporate capital structure. Deutsche Bank. Retrieved December 4, 2007, from https://www.dbbonds.com/docs/lsg/sessions/Corporate%20Debt%20Structure/media/documents/Corporate%20Debt%20Structure%20%20Main%20Body%20Only.pdf

Weil. (2013, May). A look back at sponsor-backed going private transactions. Retrieved December 2, 2013 from http://www.weil.com/files/upload/Going%5FPrivate%5FB rochure%5FMay%5F2013.pdf

Suggested Reading

Barclay, M., & Smith, C. (2005). The capital structure puzzle: The evidence revisited. Journal of Applied Corporate Finance, 17(1), 8-17. Retrieved December 4, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=16672067&site=ehost-live

Gordon, R., & Lee, Y. (2007). Interest rates, taxes and corporate financial policies. National Tax Journal, 60(1), 65-84. Retrieved December 4, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24699957&site=ehost-live

Markides, C., & Oyon, D. (1994). Stealing from thy neighbour: Leveraged recapitalizations and wealth redistribution. British Journal of Management, 5(2), 139. Retrieved December 4, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=4525623&site=eh ost-live

Myint, S., & Famery, F. (2012). The handbook of corporate financial risk management. [N.p.]: Risk Books. Retrieved December 2, 2013 from EBSCO online database eBook Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=e000xna&AN=668345&site=ehost-live

Troughton, G. H., Fridson, M. S., & Clayman, M. R. (2012). Corporate finance: A practical approach. Hoboken, NJ: Wiley. Retrieved December 2, 2013 from EBSCO online database eBook Collection (EBSCOhost). http://search.ebscohost.com/login.aspx?direct=true&db=nlebk&AN=433540&site=ehost-live