The board of directors of Baldwin Inc. met today to discuss the capital structure and dividend policy of the company. The board discussed the optimal capital structure of 50 percent debt and 50 percent equity. Management chose this capital structure because they believe that would have the highest 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 50 percent was not supported by some board members. One board member, Gregg wanted the capital structure to be 70% debt and 30% equity because he believes a high debt ratio is beneficial to shareholders. However, Jeff Warren, the CFO of the company, 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 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. Jeff continued to explain that if the company files for bankruptcy there are direct and indirect costs that Baldwin must incur.

Mr. Milosvoski, 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. He 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. He believed that costs of debt can be reduced with negative covenants and a positive covenant. 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. 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 the 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 will 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 Baldwin 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 the 50-50 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:

List three advantages and two disadvantages of the 70% debt ratio proposed by Gregg.
State five examples of direct costs, indirect costs and agency costs associated with financial distress that Jeff stated in his presentation to the board.
Explain the following cost reduction techniques suggested by Mr. Milosvoski and John Miller.
positive covenant
negative covenant
debt consolidation
Explain the rules of pecking-order theory of capital structure as suggested to the board members by Mr. Suzuki, the director of Marketing. List three implications of the pecking-order theory.
Baldwin Inc. is planned to pay dividends of $3 per share to shareholders in 2020 (total dividend is $3 million). But because of high personal taxes on dividend income, the company postponed the dividend to next 5 years when they believe a new tax legislation will be passed by Congress to give tax exemption on dividend and investment income. Suggest three alternatives to the board of how the available cash can be used in place of the dividend.
Identify four factors that can support high-dividend policy to stockholders of Baldwin?
Baldwin Inc. wants you to help them prepare a dividend policy which will guide the first dividend payout of the company in 2025. List five characteristics of a sensible dividend policy you want the board to know.

Sample Solution