CAPITAL STRUCTURE CHNAGES

The major topic for the April meeting was briefing on possible capital structure changes. The new CFO
had come Mcga from a larger corporation that was quite sophisticated in financial and governance
matters. Perhaps the most important idea that the CFO proposed involved what some would term
“financial engineering.” The company’s earnings were “flat to decreasing, “and the stock price reflected
this reality. If one believed in the future of the company, this would be an ideal time to buy the stock.
This could however, possibly render the company vulnerable to a takeover offer.

The company also had a very strong balance sheet ,and was significantly “under-leveraged, “compared
to the conventional wisdom as to the debt –to-capital structure that would most likely optimize the cost
of capital and maximize the creation of economic value. The CFO therefore proposed a stock buy-back
plan to leverage the company, thus increasing earnings per share and, hopelly, the stock price.

The CFO proposed issuing $1.5 billion of 8%,10 years subordinated notes in the public market, and using
that money to buy stock 42857143 shares at $35 a share. The interest cost would be $120 million a year,
reducing after tax earnings to $180 million from $252 million. Earnings per share could be expected to
rise from $2.52 to $3.15.equity would be reduced by the amount of the shares repurchased thus
increasing the ROE, even after reducing the earnings by the effect of the interest payments. The effect
on Rock’s incentive plan was not addressed.

Sally was intrigued. She was concerned that the foundation should be diversifying its holdings and this
would go a long way toward solving the problem. If the foundation sold half of its shares, it would
receive over $175 million tax free.

On paper, this appeared to be a positive move. How should the directors go about evaluating this
proposal? What questions should they be asking?

In addition ,based on his experience ,the CFO thought the board should understand the advantages and
disadvantages of being incorporated in the current state whose laws were not as business friendly as the
states of Virginia or Delaware. There were, in his opinion, two major problems attendant to being
registered in the current state; the legal liability of directors and the fact that judges were elected and
consequently tended to be very responsive to the interest of the plaintiff’s bar.it was his opinion and his
recommendation that the company should change its state of incorporation to Virginia.

He also thought that Mcga Corporation’s organizational structure could be streamlined. The company
currently operated through a structure of eleven major subsidiary companies, plus another dozen
business units organized for specific purposes. Each subsidiary company had its own board of directors,
as required by law. The directors were usually the CFO of the subsidiary, its CFO, and an officer from the
parent corporation. The CFO proposed that there be one director for all subsidiaries, and that director
would be the CEO of Mcga. He also suggested that some of the subsidiaries be eliminated, unless there
were strong financial or operational advantages to their continuation.it may be advantageous to keep
the poorly performing subs as wholly owned subsidiaries in the event of their sale to another entity for
stock (permitting a pooling of interest through purchase accounting for the year).this might yield a
higher sale price than straight cash.

Because of this, if Mcga proceeded with the capitalization incorporation in Virginia would provide more
comfort to underwriters and securities rating agencies because it would offer less risk of the unknown if
disputes should arise between the shareholders and the company.

The attraction of Virginia was founded on the existing business judgment rule, which states:

“A director shall discharge his duties as a director in accordance with his good faith business judgment
of the best interest of the corporation.”

The effectiveness of governance decisions would not be measured by what a reasonable person would
do in similar circumstances or by the rationality of the ultimate decision. Rather, good faith means
whether a process was engaged in that would produce a defensible business decision.in addition to
these advantages the Virginia statute provided a good deal of additional flexibility in many other
respects.

Jack Wright was pleased that the board was now discussing these kind of issues, appropriate to its
fiduciary responsibilities. He was also curious about the pros and cons of these proposed changes and
how the board would respond to them.