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LIMITS TO THE USE OF DEBT AND DIVIDEND PAYOUTS

The board of directors of Angelina Corporation met today to discuss the capital structure of the company, limits to the use of debt, dividends and other payouts. During the meeting it came up that debt provides tax benefits to the firm because interest is tax deductible whereas dividend is not. Jeff Warren, the CFO stated that when firms use equity, they cannot be forced into bankruptcy for nonpayment of dividends, but unpaid debt is a liability of the firm and nonpayment results in default and a possible bankruptcy. A board member, Robert Smith, believes that a high debt ratio increases the financial risk of the business. Jeff Warren stressed in his presentation to the board that debt can put pressure on the firm because interests and principal payments are fixed obligations that the company must pay, no matter what the profit of the company is$.$ He stated that if these obligations are not met, the company may risk some sort of financial distress and files for bankruptcy. Jeff continued to explain that if the company files for bankruptcy there are direct and indirect costs as well as agency costs that the company must incur.

Alexis Bailey, another 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. She stated that protective covenants are incorporated as part of the loan agreement and must be taken seriously because a broken covenant can lead to default. She believed that costs of debt can be reduced with negative covenants $($also called restrictive covenants$)$ and positive covenants. John Miller, the Investor Relations Officer, 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. He cited examples in Japan where large banks generally take significant stock positions in the firms to which they lend money.

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The employee representative on the board, Ms$.$ Johnson, used agency costs to explain that when a firm has debt, conflicts of interest arise between stockholders and bondholders. Because of this, stockholders are tempted to pursue selfish strategies. These strategies are costly because they lower the market value of the firm. Philip Suzuki, director of Marketing and a board member, was of the view that determining optimal debt$-$equity ratio is not an easy task and varies across industries so the company should follow the rules of the pecking$-$order theory when financing capital projects. No agreement was reached on the company's capital structure, but the CEO and Jeff believed that $40-60$ debt$-$equity ratio will minimize the cost of capital and improve the value of the firm. 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 three advantages and two disadvantages of a high debt ratio proposed by some of the board members.

$2.)$ State two examples of direct costs, indirect costs and agency costs associated with financial distress that Jeff stated in his presentation to the board.

$3.)$ Explain the following cost reduction techniques suggested by Alexis and John Miller.

i$.$ positive covenant

ii$.$ negative covenant

iii. debt consolidation

$4.($i$)$ Explain the rules of pecking$-$order theory of capital structure as suggested to the board members by Mr$.$ Suzuki, the director of Marketing.

ii$).$ The company is planning to raise $$20$ million to finance an expansion project. The company has $$8$ million retained earnings

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ii$).$ The company is planning to raise $$20$ million to finance an expansion project. The company has $$8$ million retained earnings deposited in checking and money market accounts. The company can borrow money up to $$5$ million from the bond market. Based on pecking$-$order theory, how much money should the company raise from equity financing?

iii.$)$ List three implications of the pecking$-$order theory.

$5.$ Angelina Corporation is planning to pay dividends to shareholders next year. Suggest three types of dividends that the board can consider.

$6.$ Angelina Corporation is proposing to have a dividend payout ratio of $40\%.$ The earnings of the company is expected to be $$6\mathrm{.}5$ million next year, and the number of shares outstanding is $1\mathrm{.}2$ million. Calculate the dividend per share for next year.

$7.$ Angelina Corporation is considering othe