BUS 551 Module 4 Capital Structure Example

No Debt, Steady Profits and Farmers Who Buy in Good Years: Choosing a Capital Structure for a Grain Bin Maker

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MBA Program, Aspen University

BUS 551: Corporate Financial Management

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No Debt, Steady Profits and Farmers Who Buy in Good Years: Choosing a Capital Structure for a Grain Bin Maker

Plains Steel Storage, a composite company in Grand Island, Nebraska, manufactures corrugated steel grain bins and drying equipment sold through dealers to farmers and grain elevators. It earns about $30 million a year in operating profit and has never borrowed beyond seasonal trade credit. Three generations of the founding family own all its shares. Several family members who do not work in the business would like to sell some of their shares for cash, but the company does not have enough spare cash to buy them out. The chief financial officer has proposed borrowing to fund a share repurchase. This paper analyzes how much debt, if any, the company should take on.

Does Capital Structure Matter

Modigliani and Miller (1958) showed that in a perfect market, without taxes, bankruptcy costs or differences in information, the value of a firm does not depend on whether it is financed with debt or equity. Borrowing more makes the remaining equity riskier, and shareholders demand a higher return that exactly offsets the cheaper cost of debt. The result is important not because markets are perfect but because it identifies what makes capital structure matter: taxes, the costs of financial distress, and information and incentive problems.

The Tax Benefit

Interest is deductible for tax purposes, so debt shelters income from taxes. If Plains Steel borrowed $60 million and kept that debt permanently, the interest tax shield, at a 25% combined tax rate, would be worth about 25% of $60 million, or $15 million, under the simplest assumptions. At a 7% interest rate, annual interest of $4.2 million would reduce taxes by about $1.05 million a year.

Graham (2000) estimated the tax benefits of debt for thousands of U.S. firms and found that they were substantial, equal to roughly 9.7% of firm value on average, and that numerous big, profitable firms with plenty of cash and little danger of distress borrowed far less than they could have, forgoing tax savings. Plains Steel, with steady profits and no debt, fits that description.

Why Firms Underuse Debt

Myers (1984) contrasted two explanations of capital structure. The trade-off theory holds that firms choose debt by balancing its tax benefits against the expected costs of financial distress. The pecking order theory holds that, because managers know more than outside investors, firms prefer to rely first on retained cash, next on low-risk borrowing, and to sell new shares only when nothing else will do; observed debt levels reflect a firm's history of profits and investment needs more than a target. Plains Steel's history fits the pecking order: it has funded everything from retained earnings and has never needed outside money. That does not mean zero debt is optimal now that owners want liquidity.

The Cost of Financial Distress

The tax benefit must be weighed against the risk of trouble. Plains Steel's sales follow the farm economy. In good years, when crop prices and yields are high, farmers buy bins; in bad years, they defer. In the most recent downturn, operating earnings fell to about $11 million for two years. A company with too much debt in such a period might have to cut research, lose dealers or, at worst, default. Distress costs include not only legal costs but also lost sales and talent when customers and employees doubt the company's survival.

Comparing Three Debt Levels

At $60 million, coverage in a bad year would fall to 2.6 times, close to levels that typically trigger lender covenants, and principal payments would strain cash in the downturn. At $40 million, coverage remains near four times even in a bad year. At $20 million, the company would remain very safe but capture a third of the tax benefit and buy back fewer shares.

What Lenders Will Look For

A regional bank lending $40 million to a first-time borrower will examine the company's earnings through the last farm cycle, the stability of its dealer network and the family's commitment to the business. It will likely require a covenant on the ratio of debt to operating earnings and another on minimum interest coverage, and it may ask for a security interest in the company's plant and receivables. Because Plains Steel has no existing debt and strong margins, it should be able to negotiate terms close to those offered to established borrowers, especially if it presents the downturn scenario itself rather than waiting for the bank to raise it.

The Pecking Order After the Buyback

Borrowing for the repurchase uses some of the company's debt capacity, the cushion that the pecking order suggests firms value for future investment. If Plains Steel later needs to fund a new plant or an acquisition, it will have less room to borrow. Keeping debt well below the covenant limit and repaying principal steadily preserves part of that cushion.

Recommendation

Plains Steel should borrow $40 million through a seven-year term loan with level principal payments and use it to repurchase shares from family members who wish to sell, at a price set by independent valuation. The loan should carry a covenant limiting debt to two and a half times operating earnings, with the company committing internally to keep it below two times. The tax shield, worth roughly $10 million over time, would go to the remaining owners, and the company would retain enough capacity to weather a bad farm cycle.

Effects on Remaining Owners

Family members who keep their shares would own a larger percentage of a company with some debt. Their returns would rise in good years and fall more in bad years, the trade-off Modigliani and Miller described. The recommendation balances these effects by choosing a level of debt that the company can carry comfortably through a downturn.

Conclusion

Theory explains why debt can add value through taxes and why it must be limited by distress risk; evidence suggests that firms like Plains Steel often borrow too little. For a profitable but cyclical company with owners who need liquidity, $40 million of debt captures most of the tax benefit while keeping coverage safe in a bad year.

References

Graham, J. R. (2000). How big are the tax benefits of debt? Journal of Finance, 55(5), 1901-1941.

Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261-297.

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