Rebirth: General Motors and Capital Structure Movements
Earl A. Poyser
Professor Ana Machuca
October 9, 2012
From the brink of absolute dissolving and dilapidation, General Motors has made impressive yearly strides that have come to symbolize a strong sense of perseverance, urgency, renewed purpose, and spirited fervor to restore capital structure to its original luster. GM Corporation is an American multinational automotive firm headquartered in Detroit, MI, and the world's largest automaker in 2011 by vehicle sales. It is basically the lifeblood and operational core of America's automobile manufacturing endeavors as well as a formidable ambassador fit enough to stand next to the elite entities of this crowded industry. Unfortunately, GM's standing as the perennial package of successful capital structure, business acumen, and profitability had taken a serious blow when the executives were compelled to request a government bailout in December 2008. GM, along with Chrysler and Ford, made the claim that without the financial aid from the government, the adverse effects on the already fragile economy would be exasperated beyond foreseeable recovery. GM had twice as many brands as needed, and twice as many dealerships, thanks to state franchise regulations. For them, the bailout was needed to restore the U.S. auto industry to international relevance.
Capital Structure Explanation
The company capital structure is encapsulated in the reconciliation of both debt and equity. It is based on how a firm finances its overall operations and growth by using different sources of funds. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. "A firm's capital structure includes its choice of a target capital structure, the average maturity of its debt, and the specific types of financing it decides to use at any particular time. As with operating decisions, managers should make capital structure decisions that are designed to maximize the firm's intrinsic value" (Brigham & Ehrhardt, p. 600). This was the major conundrum that General Motors managers were in towards the end of 2008 as they had to figure out the best method to extricate themselves from a calamity with possible long lasting economic effects.
GM Capital Structure Issues
"In order to fund its activities a firm typically needs some kind of funding. In financial language, the firm’s chosen set of financing sources is called its capital structure" (Byström, 2007). General Motors was, unfortunately, operating within the grips of financial distress. GM officially filed for bankruptcy protection on June 1, 2009, which gave the U.S. government 60% of it in return for $50 billion in funding to keep the company afloat while it was being revamped. Jobs, dealerships, and production were drastically cut in order to reconcile and justify the funneled in money. It was to also demonstrate to the taxpayers and government beneficiaries that the willingness to restructure a failed corporate structure was top priority in the bigger scheme of things. However, there are many naysayers who strongly believe that General Motors had brought this financial misfortune on themselves and should not have been thrown a lifesaver. "Many opposed the bailout, saying U.S. automakers brought their near-bankruptcy on themselves by not retooling for an energy efficient era, reducing their competitiveness in the global market" (Amadeo, 2012).
This concept explains the amount of risk General Motors would incur if not for the debt. It is basically the risk that is an intrinsic part of its operations, and this comes from the uncertainty about future operating profits and capital requirements. This held especially true for GM due to the fickle nature of the economy and lack of confidence in the vehicle performance when compared to outside competitors, which was evidenced in their declining sales. Lately, overall global sales volume ascended "7.6% to 9 million for the year, enough to allow it to recapture the global sales title it held for 77 years before it fell behind Toyota Motor in 2008. Revenue rose 10.8% to $150.8 billion" (Isidore, 2012). However, their bloated cost structure, including unaffordable U.S. labor contracts, and a drawn out decline in market share soon sent the company to utter demise. Economic downturn throughout the nation contributed greatly to the struggles of this company because demand variability is more directly affected in the auto industry than many of the nation's businesses. People will be more willing to forego purchasing a car, minivan, van, or truck than food or home utilities. But to truly understand the mismanagement of business risk for General Motors prior to their bankruptcy filing, one has to be made aware of the five major reasons for this, which were: (1) bad financial policies; (2) uncompetitive vehicles; (3) ignoring competition; (4) failure to innovate, and (5) managing in the bubble.
GM managers got promoted by toeing the CEO's line and ignoring external changes. Moreover, the management team was so concentrated on obtaining huge profit margins that they disregarded the importance of manufacturing quality vehicles that could viably compete with the likes of Toyota and its peers. Innovation was lacking, manufacturing costs were disproportionately high and slow, and there was an obstinate attitude toward change. When a company is content with simply straddling the line of performance and customer expectations with incessantly tepid output, it engenders a formula for underachieving and failure.
There is a great amount of financial experts who are not quite sold on the dispersing effect of the government bailout as it relates to GM's stockholders. There is a strong belief that the money now owed to the government will put a constraining burden on the funds subsequently meant for shareholders. This illustrates the concern: "The Government bailout of General Motors has not, and likely will not benefit past common shareholders because the old General Motors Company no longer exists and trading of shares in the old General Motors was halted on July 10, 2009. This is because common shareholders are among the last beneficiaries in the bankruptcy process and compensating them would have required liquidation of the company that was ruled against in the July 5th bankruptcy court proceeding.
A July 2, 2009 Wall Street Journal article on the matter confirmed that General Motors “would not have enough money to benefit common shareholders of GM" (Berry, 2009). In addition, Berry (2009) states that "one of the biggest financial losses is to the equity owners of the old General Motors who owned and held large amounts of the stock when it was valued at pre-recession levels. This could have included fund managers, market makers, individual investors, pension funds and more depending on their investing strategies." The benefits of shareholders from the new, revamped GM depends on how well it performs in the long run and how quickly the managers can acquire enough funds to recompense the debt owed to the U.S. government; and, in fact, this company has recently made significant strides toward disproving such cynical assessments of their ability to accumulate and allocate.
The Modigliani-Miller Theorem
The Modigliani-Miller Theorem is the cornerstone of modern corporate finance. This progressive mindset desired to stir the economic pot by envisioning a circumstance where the value of a firm doesn’t have to be dependent on its corporate structure. What is presently understood as the Modigliani-Miller Theorem consists of four distinct results from a series of papers in 1958, 1961, and 1963. There are as follows: (1) under certain conditions, a firm's debt-equity ratio doesn't affect its market value; (2) establishes that a firm's leverage has no effect on its weighted average cost of capital; (3) establishes that firm market is independent of its dividend policy, and (4) says that equity-holders are indifferent about the firm's financial policy. Naturally, GM would be the proponent for such theoretical machinations considering the unfortunate sequence of events which unfavorably debunked the facets of this philosophy. This firm would surely have loved if the aforementioned results were actually true within the corporate structure because the lackluster financial policies, poor debt-equity ratio, and dismal leveraging would have had no bearing on its competitive standing. Plus, there wouldn't be a need to reconcile the numerous stakeholders who would have little concern about GM's bad financial policies.
Critique of Modigliani-Miller Model
There are both advantages and disadvantages of this famous theorem. The benefits of this progressive model states, "In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure" (QFinance, 2012). On the flip side of that comes the purported disadvantage, which makes this claim: "Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios" (QFinance, 2012). And, of course, this theorem is based on some drastic assumptions that could never account for this nation's extremely jittery economic landscape in which GM was tangled.
Capital Structure Evidence and Implications
Through several studies, it has been discovered that corporate strategy plays a hugely significant role in long term success. It was also suggested that the firm’s strategy is directly affected by its leverage. This concept first came to light from economists, Michael Jenkins and William Meckling in 1976. Then in 1984, Sheridan Titman also proposed that these elements were indeed linked to one another, but he switched the causality order by saying the ﬁrm’s leverage might be influenced by its strategy. Several economists and experts in the finance field seemed to bolster these arguments for the amalgamated relationship of strategy, leverage, and profit.
The explicit consideration of strategy did help spark a growing acceptance of the concept of ‘strategy’ in financial theory. “For example, in their model for selecting the degree of financial leverage, Sandberg, Lewellen, and Stanley (1987) claimed that leverage should be increased as long as it continues to have positive consequences and does not ‘impede the firm’s ability to develop effective business strategy’” (O’Brien, 2003). Another proposal, which came from Simerly and Li (2000), states that obligations to creditors may impede the company’s ability to make strategic investments in areas such as research and development. “The authors found strong support for their proposition that a mismatch between the firm’s leverage and its environment will encumber performance” (O’Brien, 2003). Eventually, this concept came to fruition for the beleaguered and innovatively challenged managers at General Motors.
Estimating GM’s Optimal Capital Structure
One of the important factors in a company like General Motors moving toward an optimal capital structure is to uncover the amount of debt financing that maximizes the value of operations. This is the capital structure that also escalates shareholder wealth and intrinsic stock price. The $80 billion borrowed from the government has been reported to not only being fully paid back, but GM has also been said to have actually made profit. Some of the money was repaid in cash, while the remaining interest was tied up in equity shares held by the government. “Both Chrysler and GM slashed costs and unloaded debt in the process, and the US treasury has thus far recouped about 50 percent of the loans and grants made to the two companies as well as suppliers and finance institutions. The loans were either repaid in cash, or through equity shares Uncle Sam negotiated beforehand. The U.S. government holds a little more than 500 million shares of General Motors stock” (Max, 2012). Such figures ultimately encourage shareholders to invest in the dually responsible and profitable General Motors. The managers have seemingly wised up from their troubled past due in large part to pressures from disgruntled American consumers and the competition that had surpassed them in inventory sales.
In their restructuring plan for long-term viability dispatched to the U.S. government, General Motors acknowledged the errors that led them to their temporary misfortune. The Chapter 11 intervention has allowed GM to pursue a major overhaul of its business model and capital structuring as well as expediting the production of fuel-efficient vehicles. They have also engaged in manufacturing consolidation by making the agonizing yet necessary decision to downsize their workforce and discontinuing nameplates like Saturn, Pontiac, Hummer, and Oldsmobile, which has ultimately freed up their operative abilities toward an effective global initiative. Obviously, the return to past glory is still being engaged while still trying to appease weary shareholders and potential consumers. The signs of recovery can be seen in DBRS, Canada's largest credit rating agency, upgrading GM to BBB (low) from BB (high) and the much improved profit margins, "with $27 billion in net cash, and strong cash flow" (Muller, 2012). GM continues to uphold its balance sheet and pay back its debt (5 years ahead of schedule), which by all accounts demonstrates a harmonious accord of capital structure decision making.
Amadeo, K. (2012, March 28). The auto industry bailout: why GM, Ford, and Chrysler asked for
government loans. About.com. Retrieved from http://useconomy.about.com/od/