Capital Structure
©P.V. Viswanath, 1997, 1999, 2000, 2007

Tradeoffs and Theory

• Perfect Markets View: Modigliani-Miller Irrelevance Theorem
• Advantages of Debt
• Disadvantages of Debt
• Factors that explain cross-sectional variations in debt-equity ratios
• How stockholders can expropriate bondholder wealth by choosing riskier projects
• An option model of bondholder-stockholder relations
• How stockholders can expropriate shareholder wealth by increasing leverage
• The Problem of Debt Overhang
• A State Space Approach to Asset Pricing and Capital Structure
• Example of a Debt Covenant from Honeywell International Inc.

Models and Applications: Cost of Capital Approach

Capital Structure Problem and Solution

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Perfect Markets View:

 Modigliani and Miller Capital Structure Irrelevance Proposition I:

 If there are no leakages (i.e. payouts to parties other than the security holders of the firm that are a function of capital structure), then:

• The value of a company derives from the operations of the company. 

• Changes in capital structure only affect the way in which the distribution of the cash flows between stockholders and bondholders is achieved.

Hence the value of the firm should be independent of its capital structure.

 However, it may be possible to earn a premium for supplying a security or capital structure policy that is in short supply (financial clienteles).

Arbitrage-based proof:

Companies Allais (A) and Blackburn (B) differ only in their capital structure.  A is financed 20% debt and 80% equity; B is financed 10% debt and 90% equity.  Nguyen owns 1% of Allais' common stock. 

 With his current portfolio (call it X), his cashflows each year equal 0.01(C-Int_A), where IntA is the total interest paid out in that year by A (may differ from the promised payment), and C is the total operating cashflow that year for A (and B).  This portfolio will have a value of .01(0.8V_A) = 0.008 V_A. Alternatively, he could buy 1% of B's debt and 1% of B's equity, and borrow an amount equal to .01D_A, where DA = 0.2V_A is the market value of A's debt (portfolio Y).  If he puts up his interest in B as collateral, he can obtain the same borrowing terms as firm A.  This would give him a cashflow of 0.01C - 0.01Int_A, which is the same as he gets by holding 1% of A's stock.  The market value of this alternative package is 0.01V_B - .01(.2V_A).   

Portfolio	Cash flow	Value
X	0.01(C-IntA)	0.008 VA
Y	0.01(C-IntA)	.01VB - .01(.2VA)

 If V_A = V_B, then the wealth required to create the two portfolios is equal.  If, on the other hand, V_A > V_B, Nguyen can shortsell portfolio X, and buy portfolio Y.  This would create a portfolio with zero cashflows each year, but there would be 0.002(V_A-V_B) > 0 left over from the transaction, which would be pure arbitrage profit.  Hence, in a properly functioning arbitrage-free market V_A = V_B, and the value of a firm is independent of its capital structure.

MM Proposition II: The required return on equity is a linear function of the debt-equity ratio.

 

MM Proposition II with risky debt:

 Consider the following firm with a given probability distribution of terminal firm value at the end of the year and the relevant state prices in the economy. 

State of the World/Scenario	State price	Probability	Terminal Firm Value
1	0.08	0.1	100
2	0.16	0.22	80
3	0.28	0.3	60
4	0.19	0.2	50
5	0.09	0.1	30
6	0.09	0.08	20

A state price is the market price of the relevant state security, i.e. a security with a payoff of $1 in that state and zero otherwise. Given the state price of 0.08 for scenario 1, we can compute the expected return for the state security for state 1.  The expected payoff for the state security for state 1 is 0.1(1) + 0.9(0) = 0.1.  The price is 0.08; hence the expected return is 0.1/0.08 - 1 = 25%.  Similarly, we can compute the expected returns on all the state securities and any portfolio of the state securities.

Now suppose this firm has outstanding debt has a face value of $30 and matures in one year.  Then the payoffs to the debtholders can be computed as follows:

State price	Probability	Cashflow to firm	Cashflow to debtholders	Cashflow to equityholders
0.08	0.1	100	30	70
0.16	0.22	80	30	50
0.28	0.3	60	30	30
0.19	0.2	50	30	20
0.09	0.1	30	30	0
0.09	0.08	20	20	0
	E(cashflow)	60.2	29.2	31
	Price	51.6	25.8	25.8
	E(return)	16.67%	13.18%	20.16%

Hence, if we try to check up on the formula from MM II: E(R_equity) = E(R_assets) + [E(R_assets)-E(R_debt)](D/E), the RHS works out to 16.67 + (16.67 - 13.18)(25.8/25.8) = 16.67 + 3.49 = 20.16.

We can go through a similar computation for each level  of debt.  This generates the expected return relationships between debt, equity and the entire firm, consistent with Modigliani-Miller Proposition II.

 

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Why choose debt or equity to finance projects?

Advantages of debt:

• Tax advantages of debt

• the debt ratios of entities facing higher (marginal) tax rates should be higher than those facing lower marginal tax rates.
• Firms with substantial non-debt tax shields, such as depreciation, should be less likely to use debt than those firms that do not have such tax shields.
• If (marginal) tax rates rise over time, we would expect debt ratios to go up as well.
• Firms in countries where debt has a greater tax benefit would be expected to have higher debt ratios.

• Discipline characteristics of debt

• Ownership and management are separated in the corporate form of government. Hence, in spite of the theoretical ability of stockholders to control the firm, in practice, stockholders have difficulty in controlling entrenched management. The amount of time for which funds raised through debt is limited; hence the manager has to go back to the markets to justify the continued use of those funds. Firms with a lot of free cash flow (operating cash flows after taxes but before discretionary capital expenses) provide a cushion to their managers, who have funds available with a minimal need to justify the way in which those funds are used.

Costs of debt:

• Expected Bankruptcy Costs. If borrowing money increases the probability of bankruptcy and bankruptcy involves expenditure of resources, then ceteris paribus, it is better for all concerned that money be raised through equity financing rather than through borrowing. Obviously we are interested not only in the actual costs of bankruptcy if it should occur, but also the probability of bankruptcy.
• Factors affecting the probability of bankruptcy:
• size of operating cash flows relative to debt obligations
• variance of operating cash flows.
• The actual costs incurred in the event of bankruptcy or financial distress
• Direct Costs (Legal costs, costs due to illiquidity of assets in case of need to liquidate company).
• Indirect Costs (also known as financial distress costs)
• Firms that sell the promise of future servicing/future products along with the actual product, whether such servicing/products are supplied by the firm itself or by others.
• Firms that provide goods or services whose quality cannot be determined easily in the short run.
• Agency costs of debt -- the conflict between bondholders and stockholders
• Manifested in three ways:
• Choice of investments -- choosing riskier projects
• Financing decisions -- choosing more debt instead of equity to dilute existing debtholder claims
• Dividend decisions -- paying higher dividends to reduce the asset base from which debtholder claims are paid.
• To protect themselves, bondholders either
• incur the costs of monitoring directly (which reduces the amount they are willing to pay for debt securities) or
• demand debt covenants, which reduce managerial flexibility.

Factors that explain cross-sectional variation in debt ratios:

The question of debt versus equity is more relevant for the financing of assets that are long-term; for short-term assets, it makes more sense to finance them short-term, given the notion of asset-liability matching. For example, accounts receivable would be financed with short-debt, such as bank loans, or commercial paper, or with other short-term liabilities, such as accounts payable. Equity is not generally relevant, in any case.
 

Factor class	Firm/Industry Characteristics	More debt or less debt
I: Tax advantages of debt	Earnings Volatility	The more volatile earnings are, the more likely is it, that interest deductions cannot be taken in a particular year. This means that the present value of the deductions are lost, even if they are ultimately taken in a later year.
	Tax status	If a firm has accumulated losses, it will not be able to take interest deductions.
	The existence of non-debt tax deductions	If there are non-debt tax deductions, such as depreciation, there will less of a need/ability to use interest deductions.
II: Discipline characteristics of debt	Are there other ways in which manager's objectives are aligned with those of stockholders', such as stock options?	If stock options exist, debt is not as necessary for purposes of disciplining managers
	Does the firm have a high dividend payout ratio?	Dividends work, to some extent, as substitutes for debt, in this respect.
III: Expected Bankruptcy Costs
a. Actual Bankruptcy Costs and Financial Distress Costs	Whether the firm's assets are specialized or not	The more specialized the assets are, the less likely that they will fetch their market value in a short time, in the event of liquidation; hence the more specialized assets are, the less debt they can support.
	The ratio of tangible to non-tangible assets	Tangible assets are more liquid, and hence more desirable in the event of liquidation; hence the more tangible assets are, the more debt they can support.
	The durable nature of the firm's goods	The more durable the firm's goods are, the more likely that its customers will take into account the likelihood of the firm's continued existence to provide repairs and other services, in their initial decision to purchase the goods; hence the more durable the goods are, the less desirable is debt.
	How difficult it is for customers to evaluate the quality of the firm's goods.	The more difficult it is to evaluate the quality of the firm's goods, the more likely that the firm will have to underprice in the beginning, until it has built up a reputation; obviously, then, the firm wants to be around to capitalize on the quality of its products. This means that less debt is indicated.
b. Probability of Bankruptcy	Earnings Volatility	The more volatile earnings are, the more likely bankruptcy is, independent of the level of debt.
IV: Agency Costs of Debt	Nature of industry: need for flexibility	If flexibility is needed, debt is contraindicated; hence growth firms, which probably need flexibility, should have less debt.

How stockholders can expropriate bondholder wealth by choosing riskier projects

Example 1:

The manager of the firm, acting on behalf of the equity holders, has an incentive to take unduly risky projects. Consider these two projects faced by a firm with a promised payment of $500,000 to debtholders. The details of the projects and the resulting payoffs to the firm, to bondholders, and to stockholders are provided in the tables below:

Payoff to the firm 
 

	Prob.	Project 1	Project 2
State 1	0.5	$600,000	$1,000,000
State 2	0.5	$600,000	$0
Expected Value		$600,000	$500,000

Payoff to the equityholders
 

	Prob.	Project 1	Project 2
State 1	0.5	$100,000	$500,000
State 2	0.5	$100,000	$0
Expected Value		$100,000	$250,000

Payoff to the bondholders 
 

	Prob.	Project 1	Project 2
State 1	0.5	$500,000	$500,000
State 2	0.5	$500,000	$0
Expected Value		$500,000	$250,000

Under the circumstances, it is obvious that stockholders will choose Project 2 to the detriment of bondholders, and decrease firm value. On the other hand, bondholders will tend to take unduly conservative actions because they don't get compensated even if they increase the value of the firm.

In addition to the transfer of wealth between the two parties, what we see from the above example that is that both parties could end up losing, because the value of the firm as a whole could suffer. Another source of value loss is the additional expenditures that bondholders are forced to incur to prevent from being dispossessed by stockholders. These two kinds of value loss represent agency costs of debt.

Example 2:  The impact of agency costs of debt on choice of financing can be seen in this example as well.

A firm with the opportunity to invest in three different projects is considering the issuance of debt with a face value of $1600.
Suppose the state prices of all the states are the same, presumably because investors are risk-neutral (implying a risk-free interest rate of 6%).  Here are the details of the projects.

Payoffs on different projects

Scenario	1			2			3			State Price
	Proj flow	Eq flow	Debt flow	Proj flow	Eq flow	Debt flow	Proj flow	Eq flow	Debt flow
1	1000	0	1000	400	0	400	0	0	0	0.188679
2	1500	0	1500	1150	0	1150	900	0	900	0.188679
3	2000	400	1600	1900	300	1600	1800	200	1600	0.188679
4	2500	900	1600	2650	1050	1600	2700	1100	1600	0.188679
5	3000	1400	1600	3400	1800	1600	3600	2000	1600	0.188679
Exp. Payoff	2000	540	1460	1900	630	1270	1800	660	1140
Price	1886.792	509.434	1377.358	1792.453	594.3396	1198.113	1698.113	622.6415	1075.472

From the equityholders' point of view, project 3 is most desirable, followed by project 2, then project 1.  The ranking of the projects is exactly the opposite for debtholders.  If the additional required investment for each project is $1200, then debt is a viable option only if project 1 can be guaranteed to be chosen.  If monitoring is too expensive, then equity financing will be chosen over debt financing, since debtholders will only be willing to pay $1075.472 for debt with a face-value of debt.  In order to raise more than that amount, equityholders would have to raise the face value of the debt.  

If, for whatever reason, debt is chosen (and monitoring is sufficiently expensive that equityholders cannot be forced to pick project 1), then the debt can be sold for $1075.472 only, and furthermore, there will be a net loss of $200 over the first-best project.  If the cost of monitoring is $100, then debt can still be chosen. If the cost of monitoring is $200, then equity will be chosen.  Hence, firms with projects such that monitoring costs are low and firms who have few projects to choose from, will tend to have more debt than equity in their capital structure. 

An option model of bondholder-stockholder relations

In order to highlight the relationship between bondholders and stockholders, it is useful to think of the firm's securities as contingent claims. Assume that the firm is expected to last exactly one period, from today (time t=0) to tomorrow (t=1). The firm issues debt with a promised repayment of $F at time 1. Let X be the value of the entire firm at t = 1. Then the payoff to debtholders at t=1 can be rewritten as Min(F,X), while the payoff to equityholders is Max(X-F,0).

The payoff to the entire firm, X, is distributed between bondholders and stockholders, as below:

The form of the payoff function to stockholders is exactly the same as the payoff to an investor holding an American call option on an underlying asset with a terminal value of X, and an exercise price of $F. Just as the value of the call option is increasing in the volatility of returns on the underlying asset, so also is the value of the equity increasing in the volatility of returns on the firm's underlying projects, which generate the $X. Hence, stockholders have an incentive, ceteris paribus, to choose riskier projects.
 

How stockholders can expropriate shareholder wealth by increasing leverage

Suppose Ventura Productions has the following balance sheet:
 

Assets		Liabilities
Property, Plant and Equipment	1000	Equity	1000
Total	1000	Total	1000

At this point, recognizing that interest payments are tax-deductible, Ventura decides to issue $500 worth of debt, with a coupon equal to the yield to maturity required by the market; the debt, thus, trades at par.  For convenience, let us assume that the debt is 30 year debt with a yield of 8%. These funds are used to buy new assets. Assume, further, that Ventura has been able to convince the buyers of its bonds that it has no plans to issue further debt.  Bondholders recognizing that this leaves them with $3 of assets for every dollar of debt, are satisified with the deal, and the yield that they are now obtaining.  Unfortunately, they have not been careful to require Ventura to put its promise of no further debt issues into the bond indenture.
 

Assets		Liabilities
Property, Plant and Equipment	1500	Equity	1000
		Debt	500
Total	1500	Total	1500

Now, suppose that Ventura has a change of CEO.  This guy realizes that there is a potential for increasing the value of shareholder equity, proposes a further issue of debt, to the tune of another $1000.  These new bondholders are much cannier than the previous lot, having seen what happened to the firm's promises to previous bondholders.  Consequently, they require Ventura to put a clause in the bond indenture, preventing it from issuing any further debt.  Of course, the new bondholders, who have the same prority rights as the previous bondholders realize that they only have 2500/1500 or $1.6 of assets for every dollar of debt.  Consequently, they insist upon a much higher coupon rate, which is again designed to ensure that the new bonds begin trading at par. Suppose the new bond yield is 10%.

However, what happens to the price of the original bonds?  The original bonds are no less riskier than the new bonds; hence investors in those bonds will now require the same yield as the new bondholders, i.e. 10%.  But the coupon rate on the old bonds are lower -- only 8%; consequently, they must trade at a discount.  In other words, the old bonds suffer a loss in value (which works out to 94.27).  Keep in mind, though, that the total value of all liabilities (debt and equity) must be $2500, since that is the value of all assets.  The decrease in value of the old bonds must therefore mean a corresponding increase in value of the equity of the same amount.
 

Assets		Liabilities
Property, Plant and Equipment	2500	Equity	1094.27
		Old debt	405.73
		New debt	1000
Total	2500	Total	2500

As must be obvious from this example, the unforeseen increase in leverage allowed shareholders to expropriate bondholders.

Models and Applications

Cost of Capital Approach

The Weighted-Average Cost of Capital is defined as, where WACC is the weighted average cost of capital; k_e, k_d, and k_ps are the after-tax costs of equity, debt, and preferred stock, respectively; and E, D, and PS are their respective market values.

The value of the firm is the discounted present value of after-tax cash flows to the firm, where the cash flows are defined as EBIT(1-t) - (Capital Expenditures - Depreciation) - Change in Non-cash Working Capital. (Note that tax effects of capital structure decisions such as deduction of interest payments is not taken into account here, because those effects are taken into account in terms of a reduced after-tax cost of debt.)

If we can assume that the cashflows as defined above are not affected by the capital structure decision, then maximizing the value of the firm is equivalent to minimizing the weighted-average cost of capital.  However, if operating cashflows will be affected by capital structure, perhaps due to financial distress costs, then the appropriate procedure is to discount the cashflows by the weighted-average cost of capital and pick the capital structure that maximizes firm value.

The first step in any case is to compute the costs of debt and equity for different levels of the debt ratio (D/D+E+PS).

If we use the CAPM to obtain the required rate of return on equity, we can compute the levered equity beta for different levels of debt by using the following method:

• Obtain an estimate of the current beta and the current debt-equity ratio.
• Unlever the current beta, using the formula: 
• Compute the levered beta for different levels of debt using the formula .
• Use the CAPM to get the required rate of return on equity for the different debt levels.

To estimate the firm's cost of debt at different levels of debt, the procedure involves creating two schedules, one giving the relationship between a measure of default risk and a firm's underlying characteristics, including debt ratios; and the second, relating that measure of default risk to market required rates of return. The two schedules are used in tandem to relate debt ratios to costs of debt.

• Prepare the latest income statement showing the current operating income and relevant financial ratios.
• Compute the market value of the firm: Market Value of firm = Market Value of Equity + Market Value of Debt.
• For different levels of the debt ratio, compute the dollar value of debt
• Dollar Value of Debt = [D/(D+E)]*Current Market Value of Firm
• Compute the amount that will be paid as interest (Interest Rate *Dollar Value of Debt) and the financial ratios at each new debt ratio.
• Using the schedule that relates bond ratings to financial ratios, estimate what the firm's rating would be at each new debt ratio and the market interest rate that would correspond to that ration; this is the before-tax cost of debt.
• The after-tax cost of debt is computed as (1-t)*(Before Tax Cost of Debt).

Points to note:

• Effective tax rate = Statutory Rate*.  Keep in mind, however, that this correction is only an approximation to the true effective tax rate.  We might also want to do sensitivity analysis to take into account the possibility that there might be huge swings in operating income, which would impact the firm's ability to use the tax benefits of debt.
• At what interest level do we assume that the debt is refinanced? Is it at the market rate? This might be the correct assumption if investors have protective puts that allow them to have their debt refinanced at the prevailing market rates.  On the other hand, if bondholders are not protected from the dispossessive effects of capital structure changes, then we should assume that when debt is increased, the current rates on existing bonds are locked in.

Cautionary factors:

• The lookup table may not be the same for all industries. A certain Interest Coverage Ratio may be interpreted more benignly if the variance of operating income is lower. Similarly, the asset quality of all industries is not the same.  If this factor is important, then the lookup table should be modified according to the industry.
• Operating Income might be affected by changes in the capital structure of the firm. This would be the case, for example, of the pernicious effects of operating at levels where the probability of bankruptcy is high. However, a drop in bond rating might affect operating income if it affected the willingness of trade creditors to provide credit.  If customers of firms selling durable goods take the firm's debt ratio into account, as hypothesized above, once again, operating income will be affected.
• There might be other factors to take into account in the analysis. For example, the firm's CFO might want to keep the firm's credit rating sufficiently high, so that access to capital markets is assured for future investments.  This takes into account, the need for future flexibility.  Flexibility is a factor that is difficult to take into account on an entirely objective and numerical basis.  Operationally, it might take the form of optimizing capital structure, subject to a minimum credit rating.

Capital Structure Problem and Solution:

Problem 12, Chapter 19 from Damodaran, Corporate Finance, Theory and Practice

You have been asked by JJ Corporation, a California-based firm that manufactures and services digital satellite television systems, to evaluate its capital structure.  They currently have 70 million shares outstanding trading at $10 per share.  In addition, it has 500,000 ten-year convertible bonds, with a coupon rate of 8%, trading at $1000 per bond.  JJ Corporation is rated BBB, and the interest rate on BBB straight bonds is currently 10%.  The beta for the company is 1.2, and the current risk-free rate is 6%.  The tax rate is 40%.

a. What is the firm's current debt-equity ratio?

Solution: The market value of the common stock is 70m. x $10 = $700m. 
The 500,000 convertible bonds would sell at a yield of 10% if they were straight.  Hence the straight bond component of the convertibles = .  Since the convertibles trade at $1000 per bond, the equity component = $124.63 per convertible bond. 
Hence total equity = 700+125.63(0.5) = 762.32m. 
The market value of the debt component of the convertibles = 875.37(0.5) = 437.69m.  
Hence the debt-equity ratio = 437.69/762.32 = 57.41%.

b. What is the firm's current weighted average cost of capital?

Solution: The required rate of return on the equity, using the CAPM is .06 + 1.2(0.055) = 12.6%. 
The WACC = (.5741/1.5741)(1-0.4)10% + ((1/1.5741)12.6% = 10.192%, using the data from the previous section.

JJ Corporation is proposing to borrow $250 million to use for the following purposes:

• Buy back $100 million

• Pay $100 million in dividends

• Invest $50 million in a project with a NPV of $25 million.

The effect of this additional borrowing will be a drop in the bond rating to B, which currently carries an interest rate of 11%.

c. What will be the firm's cost of equity after this additional borrowing?

Solution:  After this borrowing, the market value of equity will be $762.32m - $200m + $25m. =  $586.5m.  The market value of debt will be 437.69+250=687.69m. 
Hence the debt-equity ratio will be 1.17. 
The unlevered beta = . 
Hence the levered beta will be equal to 0.89(1+(1-0.4)1.17) = 1.52.

  Hence, the cost of equity = .06+1.52(0.055) = 14.36%.

d. What will the firm's weighted average cost of capital be after this additional borrowing?

Solution:  The WACC =

e. What will the value of the firm be after this additional borrowing?

Solution:  A simple way to estimate the increase in the value of the firm is as follows:
The original firm value was $1200.  The WACC has decreased from 10.192% to 10.17%; hence the annual savings in financing costs equal (1200)(.10192-.1017).  Discounting these at the new cost of capital of 10.17%, we get (762.32+437.68)(.10192-.1017)/(0.1017) = $2.36m. 
New Firm Value= $ 1,200 (original firm value) + $ 50 (net increase in capital after capital structure changes)+ $ 25 (NPV of new project) + $ 2.36 (increase in firm value due to capital structure change) = $ 1277.36 million.

Example of debt covenant

Excerpt from

U.S. $1,000,000,000
364-DAY CREDIT AGREEMENT

Dated as of November 26, 2003

Among
HONEYWELL INTERNATIONAL INC.,
as Borrower,
and
THE INITIAL LENDERS NAMED HEREIN,
as Initial Lenders,
and
CITIBANK, N.A.,
as Administrative Agent
and
JPMORGAN CHASE BANK
as Syndication Agent
and
BANK OF AMERICA, N.A.
BARCLAYS BANK PLC
DEUTSCHE BANK AG NEW YORK BRANCH
and
UBS SECURITIES LLC
as Documentation Agents
and
CITIGROUP GLOBAL MARKETS INC.
and
J.P.MORGAN SECURITIES INC.
as Joint Lead Arrangers and Co-Book Managers

ARTICLE V

COVENANTS OF THE BORROWER

SECTION 5.01. Affirmative Covenants. So long as any Advance shall
remain unpaid or any Lender shall have any Commitment hereunder, the Company
will:

(a) Compliance with Laws, Etc. Comply, and cause each Designated
Subsidiary to comply with all applicable laws, rules, regulations and
orders, such compliance to include, without limitation, compliance with
ERISA and Environmental Laws as provided in Section 5.01(j), if failure to
comply with such requirements would have a Material Adverse Effect.

(b) Payment of Taxes, Etc. Pay and discharge, and cause each
Designated Subsidiary to pay and discharge, all taxes, assessments and
governmental charges or levies imposed upon it or on its income or profits
or upon any of its property; provided, however, that neither the Company
nor any of its Subsidiaries shall be required to pay or discharge any such
tax, assessment, charge or claim that is being contested in good faith and
by proper proceedings and as to which appropriate reserves are being
maintained.

(c) Maintenance of Insurance. Maintain, and cause each Designated
Subsidiary to maintain, insurance with responsible and reputable insurance
companies or associations in such amounts and covering such risks as is
usually carried by companies engaged in similar businesses and owning
similar properties in the same general areas in which the Company or such
Subsidiary operates.

(d) Preservation of Corporate Existence, Etc. Preserve and maintain,
and cause each Designated Subsidiary to preserve and maintain, its
corporate existence and all its material rights (charter and statutory)
privileges and franchises; provided, however, that the Company and each
Designated Subsidiary may consummate any merger, consolidation or sale of
assets permitted under Section 5.02(b).

(e) Visitation Rights. At any reasonable time and from time to time
upon reasonable notice but not more than once a year unless an Event of
Default has occurred and is continuing, permit the Agent or any of the
Lenders or any agents or representatives thereof, to examine and make
copies of and abstracts from the records and books of account of, and visit
the properties of, the Company and any Designated Subsidiary, and to
discuss the affairs, finances and accounts of the Company and any
Designated Subsidiary with any of their officers or directors and with
their independent certified public accountants.

(f) Keeping of Books. Keep, and cause each Designated Subsidiary to
keep, proper books of record and account, in which full and correct entries
shall be made of all financial transactions and the assets and business of the Company and each
Designated Subsidiary in accordance with generally accepted accounting
principles in effect from time to time.

(g) Maintenance of Properties, Etc. Maintain and preserve, and cause
each Designated Subsidiary to maintain and preserve, all of its properties
that are used or useful in the conduct of its business in good working
order and condition, ordinary wear and tear excepted; provided, however,
that neither the Company nor any of its Designated Subsidiaries shall be
required to maintain or preserve any property if the failure to maintain or
preserve such property shall not have a Material Adverse Effect.

(h) Reporting Requirements. Furnish to the Agent (with a copy for each
Lender) and the Agent shall promptly forward the same to the Lenders:

(i) as soon as available and in any event within 60 days after
the end of each of the first three quarters of each fiscal year of the
Company, a Consolidated balance sheet of the Company and its
Consolidated Subsidiaries as of the end of such quarter and a
Consolidated statement of income and cash flows of the Company and its
Consolidated Subsidiaries for the period commencing at the end of the
previous fiscal year and ending with the end of such quarter, setting
forth in each case in comparative form the corresponding figures as of
the corresponding date and for the corresponding period of the
preceding fiscal year, all in reasonable detail and certified by the
principal financial officer, principal accounting officer, the
Vice-President and Treasurer or an Assistant Treasurer of the Company,
subject, however, to year-end auditing adjustments, which certificate
shall include a statement that such officer has no knowledge, except
as specifically stated, of any condition, event or act which
constitutes a Default;

(ii) as soon as available and in any event within 120 days after
the end of each fiscal year of the Company, a Consolidated balance
sheet of the Company and its Consolidated Subsidiaries as of the end
of such fiscal year and the related Consolidated statements of income
and cash flows of the Company and its Consolidated Subsidiaries for
such fiscal year setting forth in each case in comparative form the
corresponding figures as of the close of and for the preceding fiscal
year, all in reasonable detail and accompanied by an opinion of
independent public accountants of nationally recognized standing, as
to said financial statements and a certificate of the principal
financial officer, principal accounting officer, the Vice-President
and Treasurer or an Assistant Treasurer of the Company stating that
such officer has no knowledge, except as specifically stated, of any
condition, event or act which constitutes a Default;

(iii) copies of the Forms 8-K and 10-K reports (or similar
reports) which the Company is required to file with the Securities and
Exchange Commission of the United States of America, promptly after
the filing thereof;

(iv) copies of each annual report, quarterly report, special
report or proxy statement mailed to substantially all of the
stockholders of the Company, promptly after the mailing thereof to the
stockholders;

(v) immediate notice of the occurrence of any Default of which
the principal financial officer, principal accounting officer, the
Vice-President and Treasurer or an Assistant Treasurer of the Company
shall have knowledge;

(vi) as soon as available and in any event within 15 days after
the Company or any of its ERISA Affiliates knows or has reason to know
that any ERISA Event has occurred, a statement of a senior officer of
the Company with responsibility for compliance with the requirements
of ERISA describing such ERISA Event and the action, if any, which the
Company or such ERISA Affiliate proposes to take with respect thereto;

(vii) at the request of any Lender, promptly after the filing
thereof with the Internal Revenue Service, copies of Schedule B
(Actuarial Information) to each annual report (Form 5500 series) filed
by the Company or any of its ERISA Affiliates with respect to each
Plan;

(viii) promptly after receipt thereof by the Company or any of
its ERISA Affiliates, copies of each notice from the PBGC stating its
intention to terminate any Plan or to have a trustee appointed to
administer any Plan;

(ix) promptly after such request, such other documents and
information relating to any Plan as any Lender may reasonably request
from time to time;

(x) promptly and in any event within five Business Days after
receipt thereof by the Company or any of its ERISA Affiliates from the
sponsor of a Multiemployer Plan, copies of each notice concerning (A)
(x) the imposition of Withdrawal Liability in an amount in excess of
$5,000,000 with respect to any one Multiemployer Plan or in an
aggregate amount in excess of $25,000,000 with respect to all such
Multiemployer Plans within any one calendar year or (y) the
reorganization or termination, within the meaning of Title IV of
ERISA, of any Multiemployer Plan that has resulted or might reasonably
be expected to result in Withdrawal Liability in an amount in excess
of $5,000,000 or of all such Multiemployer Plans that has resulted or
might reasonably be expected to result in Withdrawal Liability in an
aggregate amount in excess of $25,000,000 within any one calendar year
and (B) the amount of liability incurred, or that may be incurred, by
the Company or any of its ERISA Affiliates in connection with any
event described in such subclause (x) or (y);

(xi) promptly after the commencement thereof, notice of all
actions and proceedings before any court, governmental agency or
arbitrator affecting the Borrower or any Designated Subsidiary of the
type described in Section 4.01(f); and (xii) from time to time such further information respecting the
financial condition and operations of the Company and its Subsidiaries
as any Lender may from time to time reasonably request.

(i) Authorizations. Obtain, and cause each Designated Subsidiary to
obtain, at any time and from time to time all authorizations, licenses,
consents or approvals (including exchange control approvals) as shall now
or hereafter be necessary or desirable under applicable law or regulations
in connection with its making and performance of this Agreement and, upon
the request of any Lender, promptly furnish to such Lender copies thereof.

(j) Compliance with Environmental Laws. Comply, and cause each of its
Subsidiaries and all lessees and other Persons operating or occupying its
properties to comply, in all material respects, with all applicable
Environmental Laws and Environmental Permits; obtain and renew and cause
each of its Subsidiaries to obtain and renew all Environmental Permits
necessary for its operations and properties; and conduct, and cause each of
its Subsidiaries to conduct, any investigation, study, sampling and
testing, and undertake any cleanup, removal, remedial or other action
necessary to remove and clean up all Hazardous Materials from any of its
properties, in accordance with the requirements of all Environmental Laws;
provided, however, that neither the Company nor any of its Subsidiaries
shall be required to undertake any such cleanup, removal, remedial or other
action to the extent that its obligation to do so is being contested in
good faith and by proper proceedings and appropriate reserves are being
maintained with respect to such circumstances.

(k) Change of Control. If a Change of Control shall occur, within ten
calendar days after the occurrence thereof, provide the Agent with notice
thereof, describing therein in reasonable detail the facts and
circumstances giving rise to such Change in Control.

SECTION 5.02. Negative Covenants. So long as any Advance shall remain
unpaid or any Lender shall have any Commitment hereunder, the Company will not:

(a) Liens, Etc. Issue, assume or guarantee, or permit any of its
Subsidiaries owning Restricted Property to issue, assume or guarantee, any
Debt secured by Liens on or with respect to any Restricted Property without
effectively providing that its obligations to the Lenders under this
Agreement and any of the Notes shall be secured equally and ratably with
such Debt so long as such Debt shall be so secured, except that the
foregoing shall not apply to:

(i) Liens affecting property of the Company or any of its
Subsidiaries existing on the Effective Date in effect as of the date
hereof or of any corporation existing at the time it becomes a
Subsidiary of the Company or at the time it is merged into or
consolidated with the Company or a Subsidiary of the Company;

(ii) Liens on property of the Company or its Subsidiaries
existing at the time of acquisition thereof or incurred to secure the
payment of all or part of the purchase price thereof or to secure Debt incurred prior to, at the
time of or within 24 months after acquisition thereof for the purpose
of financing all or part of the purchase price thereof;

(iii) Liens on property of the Company or its Subsidiaries (in
the case of property that is, in the opinion of the Board of Directors
of the Company, substantially unimproved for the use intended by the
Company) to secure all or part of the cost of improvement thereof, or
to secure Debt incurred to provide funds for any such purpose;

(iv) Liens which secure only Debt owing by a Subsidiary of the
Company to the Company or to another Subsidiary of the Company;

(v) Liens in favor of the United States of America, any State,
any foreign country, or any department, agency, instrumentality, or
political subdivisions of any such jurisdiction, to secure partial,
progress, advance or other payments pursuant to any contract or
statute or to secure any Debt incurred for the purpose of financing
all or any part of the purchase price or cost of constructing or
improving the property subject thereto, including, without limitation,
Liens to secure Debt of the pollution control or industrial revenue
bond type; or

(vi) any extension, renewal or replacement (or successive
extensions, renewals or replacements), in whole or in part, of any
Lien referred to in the foregoing clauses (i) to (v) inclusive of any
Debt secured thereby, provided that the principal amount of Debt
secured thereby shall not exceed the principal amount of Debt so
secured at the time of such extension, renewal or replacement, and
that such extension, renewal or replacement Lien shall be limited to
all or part of the property which secured the Lien extended, renewed
or replaced (plus improvements on such property);

provided, however, that, the Company and any one or more Subsidiaries
owning Restricted Property may issue, assume or guarantee Debt secured by
Liens which would otherwise be subject to the foregoing restrictions in an
aggregate principal amount which, together with the aggregate outstanding
principal amount of all other Debt of the Company and its Subsidiaries
owning Restricted Property that would otherwise be subject to the foregoing
restrictions (not including Debt permitted to be secured under clause (i)
through (vi) above) and the aggregate value of the Sale and Leaseback
Transactions in existence at such time, does not at any one time exceed 10%
of the Net Tangible Assets of the Company and its Consolidated
Subsidiaries; and provided further that the following type of transaction,
among others, shall not be deemed to create Debt secured by Liens: Liens
required by any contract or statute in order to permit the Company or any
of its Subsidiaries to perform any contract or subcontract made by it with
or at the request of the United States of America, any foreign country or
any department, agency or instrumentality of any of the foregoing
jurisdictions.

(b) Mergers, Etc. Merge or consolidate with or into, or convey,
transfer, lease or otherwise dispose of (whether in one transaction or in a
series of transactions) all or substantially all of its assets (whether now owned or hereafter acquired)
to, any Person; provided, however, that the Company may merge or
consolidate with any other Person so long as the Company is the surviving
corporation and so long as no Default shall have occurred and be continuing
at the time of such proposed transaction or would result therefrom.

Webnotes on Equity Valuation
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