OHL Debt Ratings, Financing Choices and Dividend Impact
Ratings Assigned and Debt Classification
The 'ratings' assigned As we can see, the change in rating from BA1 to Baa3 is a substantial change in the debt rating of OHL. This resembles what happens in speculative investment grade classifications (sometimes called "junk bonds" in such contexts), for which the debt security becomes classified by Moody's as speculative and high risk.
It is clear that in the previous section the firm appeared to have more debt when viewed under the Modigliani–Miller with taxes valuation model, because tax deductibility of interest is included there; however, that effect does not fully capture the additional risk posed by excessive leverage. As we have seen in section 3 of the module, considering the costs of financial distress shows that companies cannot borrow up to an unconstrained maximum.
If a company does not have sufficient liquidity to pay its debts, it may end up in bankruptcy proceedings or liquidation, as we have observed in many firms during this financial and liquidity crisis. We have seen that there are direct costs associated with bankruptcy, but also indirect costs such as loss of market confidence and lost investment opportunities due to lack of resources to finance those investments. This is why the value we found in the previous section should be reduced by the costs of insolvency or financial distress, which would reduce their rating. Discuss what is still left in funding and in principle.
Funding, Capital Structure and Liquidity
In principle, this theory is consistent with OHL's form of financing, since they distribute only a 25% dividend; therefore the first source of funding is internal (retained earnings), and secondarily debt, because it is a company that is highly indebted. But once the firm can no longer resort to debt due to low ratings, during the same expansion it must resort to equity to fund its investments in Brazil.
Signaling Theory and Capital Increases
In signaling theory, a capital increase is often interpreted as a negative signal by the market because investors may believe the firm is issuing new securities when its stock is overvalued. That perception can lead to a fall in the company's share price and greater equity dilution.
Taking note that the Pay Out of OHL is 25%
In principle, Modigliani–Miller asserts that the market value of the company does not depend on dividend policy but on the investments and the returns obtained from them. Therefore, under the assumptions of the Gordon dividend model, an increase in the payout would have no effect on firm value if investment opportunities and returns remain unchanged.
Gordon–Saphira Assessment of Payouts and Returns
According to the Gordon–Saphira perspective, the firm should retain earnings and invest when the return on investments RF exceeds the cost of equity kp. Given the figures for OHL, the financial profitability is 182.430 / 783.990 = 23.27%. Therefore the financial return RF (23.27%) is much higher than the cost of equity kp (11.46%).
Since RF > kp, retaining earnings to finance investments is preferable. Under the Gordon–Saphira payout rationale, increasing the payout (distributing more dividends instead of retaining) would therefore decrease OHL's valuation, because it would reduce funds available for positive net present value investments.
Information and Dividend Signaling
In information (signaling) theory, a larger dividend distribution can increase shareholder value if the company is performing well, has no financial problems, and therefore has sufficient cash flows to pay increased dividends. Conversely, an increase in dividends while the firm faces financing constraints or fewer profitable investment opportunities can be interpreted negatively by the market.
Bankruptcy Costs (Direct and Indirect)
- Direct costs: legal and administrative costs of bankruptcy or liquidation.
- Indirect costs: loss of customer and supplier confidence, impaired relationships, and lost investment opportunities.
All of the above should be considered when assessing OHL's capital structure choices, the consequences of rating changes, and the implications of any decision to raise capital or adjust dividend policy.