Capital structure explained

hi my name is patty Hirsch I'm a senior editor at marketplace today I want to talk about capital structure the reason being because it's integral to this whole issue of swapping debt for equity or preferred stock for common stock in order to understand how all of that works you need to have a good feel for how the capital structure of a company works so we've shopped around for a little analogy that we could use to describe capital structure and here's one that we came up with so here is your average passenger airplane okay alright let's say okay it's kind of a wonky looking aircraft but we can all recognize it by the wings and the tail and the fact that this is a slightly unusual aircraft because it's only got I have one exit door at the front here okay only one door is the ramp that comes out and the aircraft is configured along the normal lines at the front of the aircraft we have first class then we've got business then we've got this new thing that you'll see if you go on board the aircraft these days in particular American Airlines I can say with experience which is the the it's like the air coach plus okay so we have plus and then after that of course you've got coach everyone in the rear with the gear now if this aircraft lands heavily on the ground or crashes all right prisons only got one door it means there's a very specific exit routine for everybody first class gets out first business class comes out next then this coach Plus and then coach everybody's going to have to come out in that order that's kind of like what it's like for a company whenever a company collapses okay because these classes and also equate to certain asset classes so like first class are the loans okay business class like the bonds plus plus coach class is like preferred stock okay and then coach class is like common stock okay so why do these why do these asset classes equate to these sort of classes on board the aircraft well it's all about risk okay the further back in the plane that you sit the more risk that you take okay because if the plane crashes then it's less likely that you're going to get out if the you know because of the the priority of exit so say this play if they say this plane crashes the loan holders get out first then the bondholders then preferred stockholders and the common stockholders when they get out hole that is to say they get all their money back okay so if we look at this these delineations here you see that they kind of fall into two we have debt here which is the loans and the bombs and then you have equity okay but to preferred equity is slightly different because preferred equity looks like equity but it's actually structured more like debt because there's this payment every every month that the the company has to make so all of these issues here the is asset classes loans bonds and preferred stock these guys all receive or these people all receive a payment every month okay so now if we look at this this ad this debt and equity tranche we can see that M that we can we can see what the companies leverage is what is a ratio of debt to equity is so say in this case we have an equity ratio or debt to equity ratio of 6 to 1 okay it means that the six times the amount of debt then there is two to the amount of equity okay now if a plane even at that those leverage ratios a plane can sort of fly straight and level you know no problems as long as it's making enough money to service the debt as to say to keep paying the loans the interest rate on the loans in the bonds and to keep paying the preferred shareholders but what happens whenever the company starts making less money say in a recession well suddenly it starts to head towards the ground you know in the case of Chrysler it starts to go to you know head towards a crash so what happens where you want to write the aircraft and one of the ways to write it is to convert some of these issues some of these asset classes into common stock okay so you could ask the preferred stockholders say to convert to common stock what would I do well it means that you've got you don't have to pay so much every month because you don't have to pay these preferred shareholders and maybe you go to the bondholders and you say hey guys you know would you mind converting your bonds to common stock and you do and if you did that if you managed to convince them to do that well once again you know you've reduced the amount of interest payment that you have to make every month it also reduces your leverage so say for example these preferred guys and these bond guys they all decided to convert to common stock or what does that do well it means that you've cut your leverage down your leverage is now down to say two-to-one okay means you're flying much more steadily means you've got much more people in coach now okay coaches much larger egg your equity is much larger in comparison to debt which means that you've rebounds the aircraft and you're flying much more straight and level again okay so what's the incentive of these people to convert their bonds or their preferred stock into common stock well the incentive is that if you don't do that there's a possibility that the plane could or the company could founder the company could hit the ground if the company does hit the ground then it's going to be talking about a liquidation or a bank a bankruptcy and potentially a liquidation and if there is a liquidation where you're going to have to be assessing the situation and saying to yourself okay if this if this plane is liquidated how much likelihood is there that I'm going to get my money back because the people they're going to get their money back first or the guys in first class the loan holders only once the only one the loan holders are completely paid off or the bondholders going to get their money and only when the bondholders are totally paid off is everybody else can I get their money so if you're a bond holder in this case and you're thinking about converting to common stock you're going to say to yourself am I going to get my money back if we crash or is it better for me to try and rebalance the aircraft take a haircut a so-called haircut that is to say convert your bonds into equity which is probably going to be worth less than the bonds are worth at this point but with the the the thoughts that if the plane starts to pull up if the company starts to improve then your equity is going to be worth more further down the line that's the decision that these people have to make and that's and that's the the case that's made to them whenever the company or the restructuring managers or whatever it may be are trying to get people to convert from debt or from preferred stock into common stock in order to rebalance the balance sheet of the company in order to rebalance the capital structure and make it more likely that the company will survive of course the bondholders may decide you know what maybe we'll wait to see what happens if the if the plane steams into the ground maybe we'll wait to see how bad the crash is maybe we'll wait to see what the recovery potential of the company is and whether or not I can get paid out at the end but let me tell you on the way down while the plane is heading down and they're making that decision if they make the wrong decision and everything crashes what it's going to leave everybody even the first-class ballon holders everybody very badly needing a drink

Channel: Marketplace APM

Views: 196,561

Rating: 4.9223475 out of 5

Keywords: marketplace, whiteboard, business, Paddy Hirsch, NPR, economy, economics, debt, banks, auto industry, Borrow, Spend, Cost, Supply, Demand, Big banks, Put up dough, Stake, Trust fund, Exchange, Barter, Vend, Offer, Auction, Traffic, Unload, Deal, Dump, Hustle, Recession, Austerity, Financial crisis, Thrift, Layoff, Field, Trade, Work, Career, Livelihood, Occupation, Vocation, Commerce, Financial affairs, Money, Accounts, Economy, Analysis, News, regulation

Id: 6uB1eWJz9jI

Length: 6min 43sec (403 seconds)

Published: Wed May 06 2009