It, is not surprising that financial structure and cost_of capital are closely related because credit and possible impairment to cash flows play a central role in risk analysis. Cost of capital, as with financial structure, is established by an entity's ability to produce cash flows-magnitude, growth rate, consistency, and capital intensity, as well as the other fundamental credit metrics enumerated in Chapter 8 Entities having uncertain cash flows should carry less.total debt, whereas entities having more predictable streams could have greater leverage.6 For new

I

For purposes of discussion, I refer to operating companies as opposed to companies in full or par- tial liquidation. Also excluded are companiès that have raised sufficient equity capital with a low cash burn rate so that the cash could satisfy all outstanding claims, The cash burn rate is explained

later in this chap

organizations, the financial structure should be geared toward equity and the rais- ing of equity capital if additional financing is needed, Unless the new enterprise is virtually assured of being in a position to repay borrowings, including principal,. leverage is discouraged. For a fortunate entity whose debt retirement is very likely

and prospective free cash flow is large, maximum leverage is judicious. More cyclical firms or those. with unstable cash flows will have a higher cost of debt owing to their questionable ability to repay principal and interest. If the cyclical concern is at the top of the operating cycle, where opèrating margins. free cash flow, and stock price are strongest, it should seriously consider selling shares. even if the cash is not currentlv needed. It should do this for three reasons: (1) so that it is not forced to sell high-cost equity during an ensuing downturn, (2) so that it can later take advantage of investment opportunities, including in-house research. which its weakened competitors cannot. with its low cost cap- ital. and(3) so that its finarcial strength can grow market share through pricing. Being overcapitalized has its virtues, but as mentioned, if the entity continually

taps the market at perceived peaks, it will send the wrong signal to investors (of prospective dimini shment of cash flows), causing a stock decline and making. such future sales unlikely

If the entity under analysis is being studied for its ability to retire principal pay: ments in a timely manner, it is total debt that must be used in the calculation of lever- age ratios. Debt is debt-whether it is short-term bank debt, long-term subordinated debt, sinking-fund requirements, operating leases, pension obligations, or purchase commitments. They all represent legal liabilities that must be satisfied prior to share- holders' interest. For this reason, the maturing debt must match the enterprise's ability to service it. Again, this is addressed in Chapter 8.

Many popular financial ratios consider only long-term debt; thereby subject- ing the leverage ratio to classification decision and conceivably manipulation. To consider only long-term debt might restilt in a large and inappropriate shift in lever- age ratios depending on such classification. Under Statement of Financial Accounting Standards No..78 (SFAS 78): Classification of Long Term Debt Callable bv fhe Cre ditor if there is a violation of the _debt aoreement _(covenant

Many popular financial ratios consider only long-term debt, thereby subject- ing the leverage ratio to classification decision and conceivably manipulation. To consider only long-term debt might result in a large and inappropriate shift in lever- age ratios depending on such classification. Under: Statement of Financial Accounting Standards No. 78 (SFAS 78): Classification of Long Term Debt Callable by the Creditor, if there is a violation of the debt agreement (covenant) such long-term debt might need to be reclassified as a current liability, altering both working capital and other ratios, which could impair the firn, Likewise, if the debt has a call feature and is callable within a year, it must be reclassified as a current liability, affecting working capital and similar ratios, which also could impair the

firm or affect debt

covenants.

Low leverage does not ensure an entity a low cost of capital if the firm does not generate free cash flow or have other positive metrics, as discussed in Chapter 8. As of October 1. 2009. there were 323 industrial companies having 40 percent or lower total debt/shareholders equity, a market value in exçess of $ 100 million, greåter than 10 percent cost of equity capital, and three-year negative average of free cash flow: Their five-year total stock retùrn, thereby encompassing not just the three-year period of negative free cash flow bụt two years prior, showed a negative 4.9 percent total rate of return compared with a positiye 2.4 percent for the Standard and Poor's

O

 s&p)500 In

Low leverage does not ensure an entity a low cost of capital if the firm does not generate free cash flow or have other positive metrics, as discussed in Chapter 8. As of October 1, 2009, there were 323 industrial companies having 40 percent or lower total debt/shareholders equity, a market value in excess of $100 million, greater than 10 percent cost of equity capital, and three-year negative average of free cash flow. Their five-year total stock return, thereby encompassing not just the three-year period of negative free cash flow but two years prior, showed a negative 4.9 percent total rate of return compared with a positive 2.4 percent\for the Standard and Poor's (S&P) 500 Index.

For entities undergoing large capital expansion programs in the. belief that the project will contribute to free cash flow, such as Wynn Resorts, total leverage will increase until the operating cash flows from the proiect are able to return the debt ratios back to acceptable levels. Such temporary strains-te shareholders* equity should be balanced with additional equity raises in the event that market conditions work against projected revenues and- cash flows. If` the equity raise comes after `market conditions turn down, the incremental cost of capital would be much higher.than if part of the initial fraise occurred when optimism for the proj- ect was at its peak. We see this with every recession, when capital becomes scarce

In the midst of the credit crunch in 2009, Wynn was forced to raise $175 mil- lion by selling 9.6 million shares at $19 per share, when a year earlier its stock sold at as high as $119; a mere four months after the equity 'sale, its stock was back to $57. I it had a more balanced approach to the initial capital raise during 2007, tak- into account the possibility of an économic downturn, dilution would have-. been very minor, and given its low cost of capital resulting-from its then-stronger balance sheet, Wynn stock would not have sold off as greatly during the capital crunch. Six months after the $175 million raise, Wynn raised an additional $1.6 billion by selling 25 percent of its high-growth Macau properties-through an initial public offering (IPO).

ing

Debt taken on to fund the purchase of assets should be able to be tied directly operating cash flows used in the retirement of that debt. The financing decision must match the investment decision. Banks that borrow short and loan long learn this lesson with each downturn

to

Asstated, startups, incļuding companies that are expected to incur negative cash-flows, should hatve as little debt tas possible (preferably none), along with a substantial capital cushion, Fhese companies often go through longer than expected periods of cash burn, with their only cash inflow resulting from interest income

very mmor, ana given its now cost or capital  resunng rrom Is ten-stronger balance sheet, Wynn stock would not have sold off as greatly during the capital crunch. Six months after the $175 million raise, Wynn raised an additional $1.6 billion by selling 25 percent of its high-growth Macau-properties through ar initial public offering (IPO).

Debt taken on to fund the purchase of assets should be able to be tied directly to operating cash flows used in the retirement of that debt. The financing decision -s must match the investment decision. Banks that borrow short and loan long leamn this lesson with each downturn

As stated, startups, including companies that are expected to incur negative cash fows, should have as little debt as possible (preferably none), along with substantial capital cushion. These companies often go through longer than expected periods of cash burn. with their only cash inflow resulting from interest income This was the case with a 2005 IPO, Nucryst Corporation, a medical products company based on a proprietary metal technology. While the capital raise.brought it time and cash to expand, its business never took' hold and was unable to produce free cash flow. We see in the-firm's 2008 10K balance sheet an accumulated deficit of $41 million, When an entity is continually burning cash, it remains to be seen how long it will continue as a viable independent concern