Aswath Damodaran / Edited by Del Hawley 1

Finding the Right Financing Mix: The Capital Structure Decision

Aswath Damodaran

Stern School of Business

Aswath Damodaran / Edited by Del Hawley 2

The Only Two Choices for Financing

Debt (Leverage)

• The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.

Equity

• With equity, you do get whatever cash flows are left over after you have made debt payments.

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Debt versus Equity

Debt Equity

Fixed Claim Residual Claim

High Priority on Cash Flows

Lowest Priority on Cash Flows

Interest is Tax Deductible No Tax Break on Dividends

Fixed Maturity Infinite Life

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When Is It Debt?

Ask 3 Questions:

1. Is the cashflow claim created by this financing a fixed commitment or a residual claim?

2. Is the commitment tax-deductible?3. If you fail to uphold the commitment, do you lose

control of the business?

If all three answers are “Yes”, it’s debt. Otherwise, it’s equity or a hybrid.

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Cost of Debt

Debt is always the least costly form of financing.

WHY?

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Cost of Debt vs. Equity

E(R)

Rf

β

Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be

lower. Equity

Debt

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Cost of Debt vs. Equity

AND,

Interest on debt is tax deductible, thus lowering the cost of debt even farther.

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Debt versus Equity

Factor Debt Equity

Cost Lowest Highest

Risk to the FirmHigh: Bankruptcy and volatility of cashflows

Low

Impact on Flexibility

High: Major restrictions on decision making

Low: Few restrictions on decision making

Impact on Control

Low, unless firm is in bankruptcy

Potentially High: Many owners

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The Choices

Equity can take different forms:

• Small business owners investing their savings

• Venture capital for startups

• Common stock for corporations Debt can also take different forms

• For private businesses, it is usually bank loans

• For publicly traded firms, it is more likely to be debentures (bonds) for long-term debt and commercial paper for short-term debt

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Compare Advantages and Disadvantages of Debt

Advantages of Debt

• Interest is tax-subsidized Low cost

• Increases upside variability of cashflows to equity

• Adds discipline to management

Disadvantages of Debt

• Possibility of bankruptcy/financial distress

• Increases downside variability of cashflows to equity

• Agency costs are incurred

• Loss of future flexibility

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What Does Leverage Mean?

Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.

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What Does Leverage Mean?

In financial leverage, the fulcrum is the fixed cost of the debt financing.

The small force is variability of operating income.

The large force is the variability of cashflows to shareholders (EPS)

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What Does Leverage Mean?

The larger the fixed interest payments…

The more a small change in operating profit…

Will be amplified into a larger change in EPS

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What Does Leverage Mean?

See the example spreadsheet linked to the class web page for a demonstration of financial leverage.

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What managers consider important in deciding on how much debt to carry...

A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions

Factor Ranking (0-5)

1. Maintain financial flexibility 4.55

2. Ensure long-term survival 4.55

3. Maintain Predictable Source of Funds 4.05

4. Maximize Stock Price 3.99

5. Maintain financial independence 3.88

6. Maintain high debt rating 3.56

7. Maintain comparability with peer group 2.47

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How do firms set their financing mixes?

Life Cycle: Some firms choose a financing mix that reflects where they are in the life cycle; start- up firms use more equity, and mature firms use more debt.

Comparable firms: Many firms seem to choose a debt ratio that is similar to that used by comparable firms in the same business.

Financing Hierarchy: Firms also seem to have strong preferences on the type of financing used, with retained earnings being the most preferred choice. They seem to work down the preference list, rather than picking a financing mix directly.

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Rationale for Financing Hierarchy

Managers value flexibility. External financing reduces flexibility more than internal financing.

Managers value control. Issuing new equity weakens control and new debt creates bond covenants.

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Preference rankings : Results of a survey

Ranking Source Score

1 Retained Earnings 5.61

2 Straight Debt 4.88

3 Convertible Debt 3.02

4 External Common Equity 2.42

5 Straight Preferred Stock 2.22

6 Convertible Preferred 1.72

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Why does the cost of capital matter?

Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

If the cash flows to the firm are held constant and the cost of capital is minimized, the value of the firm will be maximized.

So, if capital structure changes do not affect the cost of capital, then capital structure is irrelevant since it will not affect firm value.

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The Most Realistic View of Capital Structure…

0%

10%

20%

30%

40%

50%

60%

70%

- 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00

Ke

Kd(1-Tx)

WACC

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The Most Realistic View of Capital Structure…

The tax advantage of debt would be progressively offset by the rising potential for bankruptcy and the resulting financial distress costs, and also by the rising agency costs.

The result would be that the WACC would fall as debt went from zero to some larger amount, but would eventually reach a minimum and then start to climb.

Thus, there would be an optimal capital structure where the WACC is minimized. This would be less that 100% debt.