Capital Structure: Moving to the Optimal

Question

You are attempting to structure a debt issue for Eaton Corporation, a manufacturer of automotive components. You have collected the following information on the market values of debt and equity for the last ten years:

Year	Market Value of Equity	Debt
1985	1824.9	436
1986	2260.6	632
1987	2389.6	795
1988	1960.8	655
1989	2226	836
1990	1875.9	755
1991	2009.7	795
1992	2589.3	833
1993	3210	649
1994	3962.7	1053

In addition, you have the following information on the changes in long term interest rates, inflation rates, GNP, and exchange rates over the same period.

Year	Long Bond Rate	GNP Growth	Weighted Dollar	Inflation Rate
1985	11.40%	6.44%	125.95	3.50%
1986	9.00%	5.40%	112.89	1.90%
1987	9.40%	6.90%	95.88	3.70%
1988	9.70%	7.89%	95.32	4.10%
1989	9.30%	7.23%	102.26	4.80%
1990	9.30%	5.35%	96.25	5.40%
1991	8.80%	2.88%	98.82	4.20%
1992	8.10%	6.22%	104.58	3.00%
1993	7.20%	5.34%	105.22	3.00%
1994	8.00%	5.97%	98.6	2.60%

Using this information,

1. a. Estimate the duration of this firm's projects. How would you use this information in designing the debt issue?
2. b. How cyclical is this company? How would that affect your debt issue?
3. c. Estimate the sensitivity of firm value to exchange rates. How would you use this information in designing the debt issue?
4. d. How sensitive is firm value to inflation rates? How would you use this information in designing the debt issue?
5. e. What factors might lead you to override the results of this analysis?

ANSWER:

Answer 1

To analyze the various aspects of Eaton Corporation's capital structure and external factors, a data-driven approach could be used. Here's a breakdown based on your questions:

a. Estimate the Duration of the Firm's Projects

Analysis: To estimate the duration of the firm's projects, you can look at the fluctuations in the market value of equity and debt over the years. A stable or slowly changing value indicates long-duration projects, whereas quick fluctuations might imply shorter project durations.

Action: If Eaton's projects are long-term, consider issuing long-term bonds to match the duration. If they are short-term, short-term debt could be more appropriate.

b. How Cyclical is this Company?

Analysis: To assess the cyclicality, examine the correlation between GNP Growth and the market value of equity and debt. High correlation indicates high sensitivity to economic cycles.

Action: If Eaton is highly cyclical, flexible debt arrangements like convertible bonds or bonds with variable interest rates might be considered to mitigate risks during downturns.

c. Sensitivity to Exchange Rates

Analysis: To estimate sensitivity to exchange rates, you could correlate the changes in the Weighted Dollar index with changes in the market values.

Action: If Eaton is sensitive to currency fluctuations, consider issuing debt in multiple currencies or use financial derivatives to hedge the exchange rate risk.

d. Sensitivity to Inflation Rates

Analysis: Correlate the inflation rates with the market values of equity and debt to determine sensitivity.

Action: If Eaton is sensitive to inflation, consider issuing inflation-protected securities or floating-rate bonds.

e. Overriding Factors

Several factors might lead you to override the results:

1. Regulatory Changes: New laws or regulations might necessitate a different capital structure.
2. Market Conditions: The current interest rates and investor sentiment could impact the type and terms of the debt issued.
3. Strategic Initiatives: Mergers or acquisitions could require rapid changes in capital structure.
4. Liquidity Concerns: Cash flow and liquidity needs may dictate the immediacy and type of debt to be issued.

By applying these analyses, you can tailor Eaton's debt issue to align closely with its operational profile and financial risk tolerances.

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Answer 2

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