Brief Overview of Debt and Equity

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. While there are several different financing instruments available to a firm, they can all be categorized either as debt or equity. Furthermore, this is a choice that both private and public firms have to make.

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

When Is It Debt? Ask 3 Questions: Is the cashflow claim created by this financing a fixed commitment or a residual claim? Is the commitment tax-deductible? 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.

Cost of Debt Debt is always the least costly form of financing. WHY?

Cost of Debt vs. Equity E(R) Equity Rf Debt β Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be lower. Equity Rf Debt β

Debt versus Equity Factor Debt Equity Cost Lowest Highest Risk to the Firm High: 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

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 Equity and debt does not always mean stocks and bonds.

Compare Advantages and Disadvantages 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 This summarizes the trade off that we make when we choose between using debt and equity.

What Does Leverage Mean? Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.

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)

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

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 This survey suggests that financial flexibility (which is not explicitly allowed for in the trade off) is valued very highly. What implications does this have for whether firms will borrow as much as the trade off suggests they should? What is financial flexibility? Flexibility to do what? What do we need to assume about access to capital markets for financial flexibility to have high value? What kinds of firms will value flexibility the most?

Why does the Capital Structure Mix 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. This is the conventional valuation model for a firm. If the cash flows are the same, and the discount rate is lowered, the present value has to go up. (The key is that cash flows have to remain the same. If this is not true, then minimizing cost of capital may not maximize firm value)

The Most Realistic View of Capital Structure…

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.