1. Capital Structure: Making the Right Decision
P.V. Viswanath
Based on Damodaran’s Corporate Finance

2. A Hypothetical Scenario
Assume you operate in an environment, where
(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know their future financing needs
Assume that you super impose these assumptions on the balance sheet on the previous page. The advantages of debt go to zero, as do the disadvantages. Under such a scenario, firms should be indifferent to issuing debt.
P.V. Viswanath

3. The Miller-Modigliani Theorem
In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.
The value of a firm is independent of its debt ratio.
With the assumptions on the previous page:
The cost of capital will remain unchanged as the debt ratio changes
The value of the firm will not be a function of leverage
Investment decisions can be made independently of financing decisions
Note that if we allow for tax benefits, and keep the other assumptions, the optimal debt ratio will go to 100%.
P.V. Viswanath

4. Implications of MM Theorem
(a) Leverage is irrelevant. A firm's value will be determined by its project cash flows.
(b) The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage.
The cost of capital remains unchanged, because what you gain by substituting expensive equity with cheaper debt will be offset by the increase in the cost of equity.
P.V. Viswanath

5. Can debt be irrelevant in a world with taxes?
In the presence of personal taxes on both interest income and income from equity, it can be argued that debt could still be irrelevant if the cumulative taxes paid (by the firm and investors) on debt and equity are the same.
Thus, if td is the personal tax rate on interest income received by investors, te is the personal tax rate on income on equity and tc is the corporate tax rate, debt will be irrelevant if:
(1 - td) = (1-tc) (1-te)
Even in a world with taxes, debt could be irrelevant, if the taxes paid collectively by the firm and the investor receiving income is the same for both equity and debt income. As an example, assume that the tax rate on interest income received is 40% and that the tax rate paid on dividend income is only 20%. If the tax rate paid by the corporation is 25%, the net tax effect is the same for both debt and equity income:
After-tax income on debt = = .60
After tax income on equity = (1-.25) (1-.20) = .60
P.V. Viswanath

6. Is there an optimal capital structure? The Empirical Evidence
The empirical evidence on whether leverage affects value is mixed.
Bradley, Jarrell, and Kim (1984) note that the debt ratio is lower for firms with more volatile operating income and for firms with substantial R&D and advertising expenses.
Barclay, Smith and Watts (1995) looked at 6780 companies between 1963 and 1993 and conclude that the most important determinant of a firm's debt ratio is its' investment opportunities. Firms with better investment opportunities (as measured by a high price to book ratio) tend to have much lower debt ratios than firms with low price to book ratios.
Smith(1986) notes that leverage-increasing actions seem to be accompanied by positive excess returns while leverage-reducing actions seem to be followed by negative returns. This is not consistent with the theory that there is an optimal capital structure, unless we assume that firms tend to be under levered.
The evidence is surprisingly weak and diffuse on the existence of an optimal capital structure. There are a number of possible explanations:
Miller and Modigliani were right and capital structure does not matter very much
Capital structure matters but for reasons other than those specified in theory
Capital structure matters but the way we test for optimality is too primitie
P.V. Viswanath

7. 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.
Firms have fairly strong preferences in terms of where they would like to raise capital. They seem to prefer internal over external sources of capital and new debt over new equity.
P.V. Viswanath

8. The Debt Equity Trade Off Across the Life Cycle
The trade off changes over a firm’s life cycle and can lead to different optimal debt ratios at different points in the life cycle. The problem often is that firms make the transition from high growth to maturity in terms of cash flows and growth, but do not adjust their debt ratios to reflect this change.
P.V. Viswanath

9. Comparable Firms
When we look at the determinants of the debt ratios of individual firms, the strongest determinant is the average debt ratio of the industries to which these firms belong.
This is not inconsistent with the existence of an optimal capital structure. If firms within a business share common characteristics (high tax rates, volatile earnings etc.), you would expect them to have similar financing mixes.
This approach can lead to sub-optimal leverage, if firms within a business do not share common characteristics.
Firms often set their debt ratios by looking at other firms in their business. It is often safe to be close to the industry average (If you mess up, you have lots of company)
P.V. Viswanath

10. Preference rankings : Results of a survey
Source
Score 1
Retained Earnings
5.61 2
Straight Debt
4.88 3
Convertible Debt
3.02 4
External Common Equity
2.42
Notice that
internal equity is vastly preferred to external equity. (Is it the fear of dilution?),
straight debt over convertible debt, and
debt over preferred stock (Is that due to debt having a tax advantage?) 5
Straight Preferred Stock
2.22 6
Convertible Preferred
1.72
P.V. Viswanath

11. 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?
P.V. Viswanath

12. 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.
Managers make financing decisions, not stockholders.
P.V. Viswanath

13. Financing Choices
You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell convertible preferred stock. What would you hypothesize about the health of the company issuing these securities?
 Nothing
 Healthier than the average firm
 In much more financial trouble than the average firm
I would expect the firm to be in much more financial trouble than the average firm. Why else would it use convertible preferred stock when it could have used an alternate source of financing?
The stock price response to the issue of securities seems to mirror this financing hierarchy, with new bond issues eliciting more positive stock price responses than new stock issues.
P.V. Viswanath