1 Corporate Finance: Optimal Financing Professor Scott Hoover Business Administration 221

2 What capital structure should a firm have?  Benefits of Debt Leverage effect  DuPont: ROE = PM  TAT  LM = PM  TAT  TA/E Tax deduction on interest payments avoids dilution of shares  Drawbacks of Debt Higher risk of bankruptcy Higher costs (and possibly lower earnings)

3 Another Look at ROE  ROE = NI/E  NI = (EBIT-Interest)(1-t) = (EBIT-iD)(1-t) t  effective tax rate i  interest rate on debt D  amount of debt  We can rearrange these equations to get an expression that is more helpful.  First, recall that

4 The ROIC is entirely independent of capital structure. It follows that the second term of the last equation reflects the impact of capital structure on ROE.

5 What do we learn from this exercise?  If the after-tax interest rate on debt is below the ROIC, taking on more debt will increase ROE.  If the after-tax interest rate on debt is above the ROIC, taking on more debt will decrease ROE.  Implications optimal strategy might be to use debt whenever the after-tax interest rate on marginal debt is below the ROIC and to use equity otherwise. But….  How far into the future should we look?  The equation does not incorporate risk.  The equation ignores other important factors.

6 FRICTO Analysis  “FRICTO” is an acronym representing the important factors in determining capital structure.  F  Flexibility Issuing debt today may reduce/eliminate the possibility of issuing debt in the near future. Implication: decision is more complicated than just “debt today vs. equity today”. It may instead be “debt today and equity tomorrow” vs. “equity today and debt tomorrow.” It is important that the firm maintain the ability to raise capital as needed, particularly in the event of unforeseen happenings (lawsuits, etc).

7  R  Risk; I  Income Debt can increase value by increasing ROE, but can decrease value by increasing risk. This tradeoff is at the core of the financing decision.  C  Control Issuing stock might cause managers to lose control. The firm may instead issue (for example) convertible debt rather than equity.  allows management to retain control for a longer period of time.  If the company does well and the debt is eventually converted, managers are unlikely to lose their jobs (because they performed so well).

8  T  Timing Expectations of future economic conditions can play an important role in the financing decision. For example….  If interest rates are very high, would a company want to issue long-term, non-callable debt?  If rates are low, is there an extra incentive to issue debt instead of equity?  O  Other Suitability of collateral Market efficiency Managerial aggressiveness Liquidity Floatation costs

9 Other Comments  Difficulty: firms go bankrupt when the unexpected happens. As such, we must carefully conduct sensitivity analysis.  Firm should act to maximize shareholder wealth (i.e., maximize the PV of expected cash flows). In theory, we can do this. In reality, firms rarely conduct a thorough analysis. Instead, they rely on consideration of the FRICTO factors. Often, the decision is simply whether or not the investment bank can sell bonds with an after-tax interest rate below the expected ROIC.