GB550 Unit 9 Capital Structure Decision Example

All Debt, All Shares or a Split: A Unit 9 Capital Structure Decision for $90 Million of New Barges

[Student Name]

Purdue University Global

GB550: Financial Management

Unit 9 Capital Structure Decision

[Instructor Name]

[Date]

The barge operator, its covenant and every earnings and financing figure are composite and illustrative; the frameworks and sources cited are real.

The Need

The replacement hoppers from Unit 7 cost $39.6 million and the tank barges from Unit 8 cost $50.4 million, $90.0 million in all. The company has $420.0 million of debt at book value and 28.4 million shares trading at $22.80, and its main bank loan includes a covenant capping debt at 3.75 times EBITDA.

The Three Plans

All debt. Borrow $90.0 million at 6.4 percent, adding $5.76 million of interest to the current $24.6 million, for $30.36 million.

All shares. Sell new shares at $22.80 less 5 percent issue costs, $21.66 a share, requiring about 4.16 million new shares.

Split. Borrow $55.0 million, adding $3.52 million of interest, and raise $35.0 million from about 1.62 million new shares.

Table 1: Earnings Per Share at Expected EBIT

Expected operating income with the new barges in service is $95.7 million.

All debt: ($95.7 − 30.36) × 0.76 / 28.4 = $1.749 a share.

All shares: ($95.7 − 24.6) × 0.76 / 32.56 = $1.660.

Split: ($95.7 − 28.12) × 0.76 / 30.02 = $1.711.

Indifference point. Setting the all-debt and all-share earnings per share equal and solving for EBIT gives $69.7 million. Above that level, debt gives shareholders more earnings per share because fixed interest is spread over fewer shares; below it, the equity plan wins.

At expected EBIT, debt is the best plan by about 9 cents a share. The question that matters is how likely EBIT is to fall below $69.7 million, and what else happens to the company when it does.

Table 2: A Low-Water Year

The company's own history includes low-water years when barges load light and tows slow down. In the most recent, EBIT fell to about $61.0 million and EBITDA to about $132.0 million. Replaying that year under each plan:

All debt. Interest coverage falls to 61.0 / 30.36 = 2.01 times. Debt of $510.0 million reaches 3.86 times EBITDA, above the 3.75 covenant.

All shares. Coverage of 2.48 times; debt stays at $420.0 million, 3.18 times EBITDA.

Split. Coverage of 2.17 times; debt of $475.0 million is 3.60 times EBITDA, under the covenant.

The all-debt plan is best in an average year and breaches the covenant in a bad one, and the bad year is the one the company has already lived through.

A breach would let lenders demand repayment or reprice the loan at the moment earnings are weakest. That cost never appears in an earnings-per-share table, which is why the covenant carries so much weight here. Graham and Harvey (2001) found that when surveyed executives explained their debt choices, they put flexibility and credit ratings at the top of the list, ahead of the tax savings from interest.

How Likely Is a Bad Year?

The indifference point of $69.7 million is about 27 percent below expected EBIT. Over the past twenty years, the company's operating income fell that far below its trend in roughly five years, almost all of them low-water years on the upper river, so the chance of a year below the indifference point is about one in four. That is far too frequent to treat as a remote risk. In an ordinary year, debt adds about 9 cents a share; in roughly one year in four, it would cost shareholders earnings per share and, under the all-debt plan, put the company in breach of its covenant.

How Much Room the Split Leaves

The split stays under the covenant in the replayed low-water year, at 3.60 times, but not by much. The covenant would bind if EBITDA fell to about $126.7 million, 4 percent below the replayed year. A deeper drought, or a second low-water year before any debt is repaid, could reach that level. The split is therefore safer than all debt, not safe in every case, and the company should pair it with a plan to repay part of the new debt from operating cash in the first two years, which Unit 10 builds in.

Table 3: Market Debt Ratios

Using Unit 6's market values, $405.1 million of debt and $647.5 million of equity:

All debt: $495.1 million of $1,142.6 million, 43.3 percent.

All shares: $405.1 million of $1,142.6 million, 35.5 percent.

Split: $460.1 million of $1,142.6 million, 40.3 percent.

Weighing the Plans

All debt gives the highest expected earnings per share but breaches the covenant in a low-water year and pushes the debt ratio to 43 percent.

All shares is safest but dilutes earnings per share by about 9 cents and sells shares at a price the Unit 4 models suggest already reflects optimistic expectations, which would be a good time to sell from the company's side but a signal investors may read as management thinking the shares are fully priced. Myers (1984) describes this signaling effect as one reason firms rank their sources, using retained cash before borrowing and treating a share sale as the last resort.

Split keeps the covenant intact in a bad year, gives up about 4 cents of expected earnings per share against all debt and lands the debt ratio near 40 percent.

Target Structure

The paper recommends a target of about 40 percent debt at market value. Barge operators hold resalable assets and fairly steady contracts, which support moderate borrowing: secured lenders can lend against the barges at lower rates, as Unit 3 showed. River-level risk limits how far that can go, because EBITDA can fall by 15 percent or more in a low-water year. Brealey et al. (2023) describe the target as a balance between the tax value of debt and the cost of financial distress, and for this company the covenant is where distress would begin.

Recommendation

Fund the $90.0 million with roughly $55.0 million of debt and $35.0 million of equity or equity-equivalent sources, and hold a target near 40 percent debt at market value. Unit 10 examines whether retained cash and a sale-leaseback can supply the equity portion without issuing new shares.

Limits

The low-water replay uses one past year; a longer drought or two consecutive low-water years would test the split as well. The 6.4 percent borrowing rate assumes current spreads, which Unit 3 showed could widen if coverage weakened. A rate one point higher would lower the all-debt plan's expected earnings per share to about $1.725, still above the split.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2023). Principles of corporate finance (14th ed.). McGraw Hill.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 39(3), 574-592. https://doi.org/10.1111/j.1540-6261.1984.tb03646.x