In the scenario given, without an alternative, OCF probably has to initiate changes in its capital structure to drive off hostile takeover attempts from Wickes. There are a few a ways the capital structure can be changed, i) recapitalize by retiring equity with debt (swap), ii) simply assume more debt, iii) issue more shares, or iv)buy back shares. An under levered firm can increase its debt ratio by borrowing money and buying back stock or paying a super dividend to its stock holders. Borrowing money increases the debt level, while buying back stock reduces number of outstanding shares, thereby decreasing MVE and paying dividend reduces stock price, thereby reducing MVE as well. OCF can also use debt for equity swap thereby increasing leverage very fast. A key feature of recapitalization is also that the target company may issue more stock to its management there by giving them more control after recapitalization.
Analysis of the Issue
Leveraged recapitalization is the easiest way to change the capital structure of the company if the company can ensure the interest payments of the debts. Although value flows from higher leverage, the firm will be restricted by bond covenants that prohibit the firm from taking certain kind of projects or impose huge penalties if it undertakes certain initiatives. Increasing debt ratio may reduce the cost of capital of the firm overnight but it changes the nature of the firm. Managers who are accustomed to operating in a low stress environment of a predominantly equity financed firm will have to adjust quickly to the cash flow demands of the highly levered firm. It may bring in discipline on the part of management in risk assessment and project selection. But it also brings in decision paralysis for managers who may not want to undertake slightly risky projects at all for the fear of default. The need to make interest and principal payments of the debt will induce managers to undertake projects that have... [continues]
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