What role did Iridium’s financial strategy play in it’s failure?

What are the

consequences of financial strategy for firm value?

The key issue with iridium’s financial strategy was management’s failure to evaluate
the project as a real option and objectively assess the timing at which capital, if at all,
should be invested.

Modligani and Millear suggested capital structure was irrelevant provided a firm’s
investment decisions were taken as given. Their irrelevance proposition assumes
financing and investment decisions are separable and independent. When this
assumption holds, various financing decisions e.g. firm’s organisational, capital and
ownership structures do not impact firm structure or investment decisions as
regardless of whether financed through debt or equity the value of overall cashflows
should be unchanged.

However, this theory fails to explain the value which Motorola was able to derive
through establishing a separate legal entity to undertake the project and incur
substantial transaction costs in negotiations with numerous parties. The theory also
fails to explain why many projects are financed with high debt levels (circa. 70%+)
despite substantial risks and minimal tax shields.

Thus in reality it is clear that capital structure matters as it affects investment

decisions and subsequent cash flows available to capital providers.

From Motorola’s perspective, establishing the project through a legally independent

entity financied by non-recourse debt proved a clever strategy. Despite Iridium’s
bankruptcy, creditors did not hold any claims on profits derived from Motorol’s other
projects and thus, this structure enabled Motorola to remain solvent. Motorola could
perhaps have undertaken the initial research phase within its own enterprise and
subsequently, if this had proved promising, established the independent entity at a
later date. This would also have enabled Motorola to lower their own tax liability
given increased research expenditure within it’s accounts.

1. Was Iridium’s target debt-to-total capital ratio of 60% too high?

Categorising Iridium as a utility company - on the basis that once complete it would
have high margins and steady cash flows - is questionable. Exhibit 7 conveys a large
variance between the Debt to Total Capital statistics in 1999 for Telecommunication
companies [24-33] as compared to utilities [52-57]. The high target leverage ratio
cannot be explained through the Trade of Theory given Iridium’s tax rate of 15%.
Instead, it appears agency reasons underpin the target leverage ratio: management
held only 1% of equity and the project had a projected EBITDA of $5bn resulting in a
high cost of equity.

Peer Group Comparison and Credit Rating Analysis:

Empirical evidence illustrates that each industry has an industry-specific effective
capital structure level. Peer group comparison is a good starting point to determine the
optimal capital strusturestructure. From Exhibit 8, we see that many players in the
telecommunications sector had high debt-to-capital ratio as a result of aggresive
investment in mobile communication,. In this case, it is meaningful to analyse
companies with investment-grade credit ratings and determine what it takes to achieve
such a rating. As we can conclude from Exhibit 8, companies with investmen-grade
credit ratings, i.e. BBB and above, have significantly lower leverage: the debt-to-total
capital ratios ranges from 11%-20%. This indicates Iridium's target ratio of 60% is
too high.

Cash Flow Analysis:

Iridium's agressive growth strategy drives a need for cash. We projected cash flow
and funding needs in two scenarios to test the robustness of the capital structure (see
table below). A good capital structure should have enough reserves to absorb risk.
From the table, we find that in 1998-2001, a huge amount of capital is required. GIven
the key drivers just described, the company could only do two things: either reduce
its growth plans and capital spending, or issue new capital.

Did Iridium have the right type or amount of debt?

It’s questionable whether Iridium held too much bank debt: Bank debt often has
restrictive covenants that require the borrower to comply with certain provisions and
financial tests throughout the life of the facility. As evident from Page 8 “Table B” of
the Report, the covenants included were too strict for Iridium to realise. Iridium’s
reliance on particular creditors is also questionable, as the company may have been
able to renegotiate to a greater extend had they maintained a diversified creditor base.

Senior bank loans have lower issue costs, are simplier to restructure and their duration
is aligned with the life of the satellites. Iridium began financing the project with
equity investments during the research stage (riskiest) as debt would be mispriced due
to risks and asummetric information. During the development stage, Iridium brought
in more equity, convertible debt and High Yield debt. This portfolio matches the risk
profile then.

Given Iridium was structured as a project, the company would have faced high
spreads on debt to account for unique risks such as technological failure, regulatory
failure; currency, sovereign and inflation risks and the need to replace the satellites
every 5 years. The lack of security, liquidity and information available rendered
project debt more expensive than corporate finance i.e. in corporate finance the
enterprises overall risk is diversified over all its activities, the cost of equity is also
usually lower. The spread may be adjusted downward (or upward) if it is tied to a
performance-based grid based on the borrower’s leverage ratio or credit ratings.

Raising debt through strategic partners, instead of through public markets, may have
proved a clever decision on the basis of prevailing market conditions and perhaps
offered a quicker avenue to access capital due to waiveringwavering of some due
diligence efforts.

Did the company raise debt financing in the optimum order vis-à-vis equity?

Assuming high debt levels increases bankruptcy risk for the firm, which in turns leads
to an increased cost of equity capital. Moreover, debt financing is accompanieds by an
obligation to meet interest payments and comply with covenants. Such structuring can
offer a credit monitoring mechanism and provide a sense of discipline e.g. in this
instance, the bank loan default which seemed to trigger the bankruptcy avoided fresh
capital being invested into a failed project. However, careful planning must be
deployed to ensure cash flow shortages will not arise.

By contrast, under equity financing dividend payments are discretionary rather than
obligatory and thus, issuing equity provides more flexibility. Equity contibutions
further provide a cushion for lenders in the event the company’s enterprise value
deteriorates as equity holds a residual claim on company assets [Pecking Order
Theory]. Thus, in an attempt to save the company Iridium could have considered
issuing more equity.

(IPO ---only raise 240 m, could have financed more because equity issuance has
high fixed transaction costs, it is probably best to issue a large amount of equity
capital in year 1997 )