Are Firms Now Vulnerable to an Economic Slowdown
Did the authors conclude that firms had been using significantly higher level of debt from 1995 through 1999? Ans. Yes, the authors concluded that firms had been using significantly higher level of debt from 1995 through 1999. According to the authors, the build-up of debt in the late 1990s raised concerns about the U. S. nonfinancial corporate sector’s health and vulnerability to economic downturns. It had been seen that, between 1995 and 1999 the outstanding debt of nonfinancial corporations rose a weighty 46 percent- a trend typified by last year’s increase of 12 percent.
Viewed as a share of GDP, such debt had reached to an extraordinary height at that time. This rapid growth in corporate debt also advanced some questions about the financial health of the sector and indirectly, about the sensitivity of other sectors to economic troubles. This seemingly high level of debt had concerned some observers, who wandered whether it had made the nonfinancial corporate sector financially weak and vulnerable to economic downturns. Such concerns had gained credibility from the recent worsening of other gauges of corporate health, notably default rates and recovery rates on defaulted debts.
Question no. 02 (a). Has debt been rising relative to the level of market value of equity during the study period? Ans. No, debt has not been rising relative to the level of market value of equity during the study period. To illuminate this statement, we can recall to what the authors have said about this. To show the relationship between borrowing and market value of equity, the authors have used the “leverage ratio”. Leverage can be thought of as the ratio of a corporation’s debt to its long run earning capacity.
They have used a firm’s long-plus short term debt as a share of its stock market value to find out the leverage. Then to cumulate individual firm’s leverage ratios into a sector wide average, they weighted firms by their stock market value. Calculated in this way, average leverage for nonfinancial firms declined fairly steadily from 0. 35 in late 1995 to 0. 22 in September 1999- despite the coexisting rise in overall debt. In essence of this, nonfinancial corporations in September 1999 on average had debt liabilities with a face value only slightly more than one-fifth the value of their outstanding equity.
Moreover, average corporate leverage for the nonfinancial sector was rather low relative to the post 1974 average of 0. 47. So the borrowing by the nonfinancial corporate sector has been moderate relative to equity growth. Question no. 02 (b). What implication might that have for a firm’s weighted average cost of capital? Ans. We know, Ka = Wi Ki + Ws Ks + Wp Kp. Where, Ka = weighted average cost of capital. Wi = proportion of long-term debt in the capital structure Ki = cost of long-term debt Ws = proportion of common stock in the capital structure Ks = cost of common stock Wp = proportion of preferred stock in the capital structure Kp = cost of preferred stock Now cost of capital is a term used in the field of financial investment to refer to the cost of a company’s funds (both debt and equity), or, from an investor’s point of view “the shareholder’s required return on a portfolio company’s existing securities”. It is used to evaluate new projects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
As we have seen in the article that the build-up of debt in the late 1990s on the nonfinancial corporate sector reached an extraordinary height. This seemingly high level of debt concerned some observers who wondered whether it made the nonfinancial corporate sector financially weak and vulnerable to economic downturns. From the above definition it is clearly understandable that, the effect of long-term or short-term debt on capital structure is very crucial. The same scenario is applicable for the common stock and preferred stock also.
In the article the authors have used 3 measures of corporate health- leverage, liquidity and overall solvency, to govern the nonfinancial corporate sector’s exposure to economic distress. At a certain point the authors have used long-term debt instead of long-plus short term debt, to calculate the leverage. If the level of debt, relative to the market value of equity rises, the value of equity or common stock will fall because as debt rises, the proportion of debt in the capital structure growths also (and vice-versa). Similarly as the value of equity falls, the proportion of common stock in the capital structure shrinkages too (and vice-versa). As a result, the health of the corporate sector also becomes thinner with the higher level of debt. As stated in the article- a measure of borrowing using long term debt, may be useful if one is interested primarily on leverage as an indicator of long term solvency. But one must consider short-term debt and total liabilities like accounts payable also as they tend to grow during time of financial distress. From the definition we can understand that if a firm uses a high level of borrowing, its financial health as well as overall solvency fall down.
Firms with high debt levels relative to earning capacity (i. e. market value of common stock or equity) can be vulnerable to economic troubles like an increase in interest rate or a major stock market correction. Question no. 03. What were the author’s conclusions with respect to the vulnerability to a significant decline in stock prices? Ans. It has been seen in the article that U. S. corporate debt has grown rapidly in the late 1990s. Between 1995 and 1999, the outstanding debt of nonfinancial corporations raised a hefty 46 perent.
This seemingly high level of debt made some observers anxious and made the corporation vulnerable to financial downturns. In the article, the authors whether concerns over the build-up of U. S. corporate debt were in fact vindicated. To examine the health of the nonfinancial corporate sector, the authors used 3 key measures of corporate health- leverage, liquidity and overall solvency. After these, they also considered how the corporate sector might fare in the face of an economic challenge such as a major stock market correction or a large rise in interest rates.
We can see from the article that the prices of stock in the late 1995 were a benchmark which offered the advantage of imposing the largest price declines on the firms. The average stock price decline implied by that scenario, relative to September 1999, is a sizeable 57 percent. Now if the stock market declined dramatically from its level in late 1999, when the most recent figures were compiled, the authors’ findings suggest that despite the decline, the corporate leverage would remain manageable.
In this scenario, the face value of outstanding debt as a share of outstanding equity at non-financial corporations would rise to an average of 0. 42. Although well above the late 1992 value of 0. 22, the value would still be below the historical average of 0. 47. It should be also noted that the firms whose share prices would likely flip the most that is high tech firms- tend to have low leverage. Corporate solvency, too, would remain comfortably above its historical average after a major stock market correction. As measured by Altman’s Z-score, solvency at 1995 prices would be 7. 2- a value below September 1999’ value of 9. 7 but still more than double the historical average of 3. 3. Question no. 04. Were large firms or small firms viewed as using more financial leverage in the study period? Ans. In the article the authors used- leverage, liquidity and overall solvency- to measure the health of nonfinancial corporate sector. Leverage is the ratio of a corporation’s debt to its long-run earning capacity. Measured in this way, average leverage for nonfinancial firms declined from 0. 35 in late 1995 to 0.22 in September 1999- despite the concurrent rise in overall debt. But the central measure of leverage used in the article could be distorted by the enclosure of high-tech firms in the sector wide average. In general, leverage for these firms tends to be quite low and until very recently, the firms’ stock prices had risen particularly rapidly. Thus the improvement of average leverage could have been driven primarily by the high-tech sector, which includes biotech and communication firms as well as firms directly engaged in the design and construction of computer hardware and software.
As these firms’ weight in the overall average grows each year, their low leverage could pull the sector wide average down further. After excluding the high-tech firms, the average leverage rose to 0. 30 to 0. 22- still below the post 1974 average of 0. 50. So we can conclude that small firms were viewed as using more financial leverage than the large firms in the study period. Question no. 05. What were the author’s conclusions with respect to the vulnerability to a significant rise in interest rate? Ans.
At the end of the article, the authors have discussed the vulnerability of the U. S. nonfinancial sector due to either a major market correction or a significant rise in the interest rate. It has been seen that as the interest rate rises, corporate liquidity hampers the most. To ensure this, the authors considered three situations- 1. They assumed that interest rate would rise by the same amount that they raised, on average, during the four quarters before each of the previous recessions. 2. They considered how these interest rate increases would affect total interest expense.
To provide an accurate estimate of the change in interest expense, it was needed to know much of the outstanding corporate debt would endure a higher interest rate, say after one year. Fortunately this information was available. They also needed to know the amount by which interest on that debt would rise. Unfortunately this information was unavailable. 3. It was also needed to know the extent to which each firm had hedged its exposure to interest rate changes. Unfortunately this information was also unavailable.
To recover these limitations, they constructed two estimates of the effect of a rise in interest rates on total interest expense- one that should exceed the actual outcome and one that should fall short of it. The first assumption almost certainly overstates the true increase in interest expense where the second one surely understates it. All these states us that after a large interest rate rise, the liquidity risk of the nonfinancial corporate sector- measured by the ratio of interest expense to current asset- would lie between 0. 176 to 0. 193 at that time which was much higher than 1974 average of 0. 167. This implies that there was a severe liquidity risk in the sector. Question no. 06. According to the authors, were firms in a good or bad position in spite of their high level of corporate debt? Ans. According to the authors, U. S. nonfinancial corporate sector was in a good position despite the sector’s high level of debt. The reasons were- the borrowing had been moderate relative to equity growth and the efficient uses of borrowed fund in the capital structure.
The authors used 3 key measures- leverage, liquidity and overall solvency- to measure the health of that sector and the results showed that despite the sector’s rapid growth in debt, the nonfinancial corporate sector was in a good financial health. Leverage as calculated, for nonfinancial firms declined fairly steadily- from 0. 35 in late 1995 to 0. 22 in September 1999 which was lower than the post-1974 average of 0. 47. The results remained the same even after using the different measures (like long-term debt in the place of long-plus short term debt) to calculate leverage.
The authors focused on three common liquidity ratios- interest expense to current assets, interest expense to cash flow and current liabilities to current assets. Despite differences in the liquidity ratios, all three confirmed that the liquidity risk of nonfinancial corporate sector had not risen sharply during the late 1990s. In addition, the ratios suggested that the sector’s liquidity risk was not very high at that time. To measure the overall solvency, the authors used a summary measure of corporate health called a Z-score.
This score is a combination of five accounting ratios that assess leverage, liquidity, sales, working capital and retained earnings. The Z-scores (Altman’s Z-score, BMW Z-score and Shumway Z-score) for the U. S. nonfinancial corporate sector showed that the likelihood of bankruptcy in the sector declined on average in the late 1990s. So, we can tell that the sector was in a good financial position. The sector as a whole would likely survive a major stock market correction without a huge disruption, but a large rise in the interest rate could bring the sector’s liquidity risk back to the relatively high levels common in the 1980s.