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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.
Aswath Damodaran / Edited by Del Hawley 3
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
Aswath Damodaran / Edited by Del Hawley 4
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.
Aswath Damodaran / Edited by Del Hawley 5
Cost of Debt
Debt is always the least costly form of financing.
WHY?
Aswath Damodaran / Edited by Del Hawley 6
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
Aswath Damodaran / Edited by Del Hawley 7
Cost of Debt vs. Equity
AND,
Interest on debt is tax deductible, thus lowering the cost of debt even farther.
Aswath Damodaran / Edited by Del Hawley 8
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
Aswath Damodaran / Edited by Del Hawley 9
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
Aswath Damodaran / Edited by Del Hawley 10
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
Aswath Damodaran / Edited by Del Hawley 11
What Does Leverage Mean?
Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.
Aswath Damodaran / Edited by Del Hawley 12
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)
Aswath Damodaran / Edited by Del Hawley 13
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
Aswath Damodaran / Edited by Del Hawley 14
What Does Leverage Mean?
See the example spreadsheet linked to the class web page for a demonstration of financial leverage.
Aswath Damodaran / Edited by Del Hawley 15
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
Aswath Damodaran / Edited by Del Hawley 16
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.
Aswath Damodaran / Edited by Del Hawley 17
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.
Aswath Damodaran / Edited by Del Hawley 18
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
Aswath Damodaran / Edited by Del Hawley 19
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.
Aswath Damodaran / Edited by Del Hawley 20
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
Aswath Damodaran / Edited by Del Hawley 21
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.