You are the manager of a company that produces automobiles. A union contract wil

Question

You are the manager of a company that produces automobiles. A union contract will come up

for renegotiation in two months and you wish to increase your firm’s bargaining power prior

to hearing the union’s initial demands. The union is likely to ask for a 25 percent increase

from existing wage levels of $20 per hour for the 1,000 workers at your company. Workers

typically work 2000 hours per year. The firm has $100 million of debt outstanding at an

interest rate of 10 percent annually, and an equity market value of $200 million. Income

before interest is $20 million per year. Assume no taxes.

What specific financing strategies would you implement and why?

Explanation / Answer

Currently total labour cost is 2000X1000X20=40 Million USD, if the wages are incresed by 25%, it will lead to additional cost of 10 Million USD, the firm has EBIT of 20 Million out of which 10 Million is required to be paid as Interest on 100 Million debt.

If the firm will accept the demand of union, it will lead to wipe there complete profits.

In this kind of situation if a firm will issue new equity for financing, it will lead to transfer wealth from shareholders to long term debt holders and put the firm in worse bargaining position.

so in such kind of situation and to get a better bargaining position, the firm should take new debt for financing, suppose in the above situation if additional debt of 80 Million is taken, so now the total debt is 180 Million and interest payout is 18 Million, this lead to only 2 million remains which can be distributed to labour, so the firm will be in good bargaining position, this strategy can be taken for such firms where the wage is negotiating without any schedule and they have a flexible capital structure, where they can change between debt and equity easily.

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