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Aswath Damodaran / Edited by Del Hawley1 Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business.

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Presentation on theme: "Aswath Damodaran / Edited by Del Hawley1 Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business."— Presentation transcript:

1 Aswath Damodaran / Edited by Del Hawley1 Finding the Right Financing Mix: The Capital Structure Decision Aswath Damodaran Stern School of Business

2 Aswath Damodaran / Edited by Del Hawley2 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.

3 Aswath Damodaran / Edited by Del Hawley3 Debt versus Equity DebtEquity Fixed ClaimResidual Claim High Priority on Cash Flows Lowest Priority on Cash Flows Interest is Tax DeductibleNo Tax Break on Dividends Fixed MaturityInfinite Life

4 Aswath Damodaran / Edited by Del Hawley4 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.

5 Aswath Damodaran / Edited by Del Hawley5 Cost of Debt Debt is always the least costly form of financing. WHY?

6 Aswath Damodaran / Edited by Del Hawley6 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

7 Aswath Damodaran / Edited by Del Hawley7 Cost of Debt vs. Equity AND, Interest on debt is tax deductible, thus lowering the cost of debt even farther.

8 Aswath Damodaran / Edited by Del Hawley8 Debt versus Equity FactorDebtEquity CostLowestHighest 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

9 Aswath Damodaran / Edited by Del Hawley9 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

10 Aswath Damodaran / Edited by Del Hawley10 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

11 Aswath Damodaran / Edited by Del Hawley11 What Does Leverage Mean? Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.

12 Aswath Damodaran / Edited by Del Hawley12 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)

13 Aswath Damodaran / Edited by Del Hawley13 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

14 Aswath Damodaran / Edited by Del Hawley14 What Does Leverage Mean? See the example spreadsheet linked to the class web page for a demonstration of financial leverage.

15 Aswath Damodaran / Edited by Del Hawley15 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 FactorRanking (0-5) 1. Maintain financial flexibility4.55 2. Ensure long-term survival4.55 3. Maintain Predictable Source of Funds4.05 4. Maximize Stock Price3.99 5. Maintain financial independence3.88 6. Maintain high debt rating3.56 7. Maintain comparability with peer group2.47

16 Aswath Damodaran / Edited by Del Hawley16 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.

17 Aswath Damodaran / Edited by Del Hawley17 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.

18 Aswath Damodaran / Edited by Del Hawley18 Preference rankings : Results of a survey RankingSourceScore 1Retained Earnings5.61 2Straight Debt4.88 3Convertible Debt3.02 4External Common Equity2.42 5Straight Preferred Stock2.22 6Convertible Preferred1.72

19 Aswath Damodaran / Edited by Del Hawley19 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.

20 Aswath Damodaran / Edited by Del Hawley20 The Most Realistic View of Capital Structure…

21 Aswath Damodaran / Edited by Del Hawley21 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.


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