Financing Decisions and The Cost of CapitalWhere do Firms Get Their Money?Slide 4Slide 5Where Do Small Businesses Get Money?What Happens As Firms Get Larger?What is the Difference Between Debt and Equity?Recent Trends in FinancingSlide 14Slide 15Capital Structure: How should a firm structure the liability side of the balance sheet?One possible answer: It makes no difference.Irrelevance Proposition IIWACC under IrrelevanceSlide 20What About The Tax Deductibility of Interest?Proposition II with TaxesProposition IILimits to The Use of DebtBankruptcy CostsAgency costs of debtUnder-investment ProblemDisciplinary Power of DebtA Theory of Capital StructureSlide 30Financing DecisionsChoosing an Amount of DebtExampleRalph’s DilemmaRalph’s Dilemma cont…Slide 36Slide 37Example: BK IndustriesExample: BK Industries RevisitedDelevered Betas with debt/equity ratiosUnlever Latec’s Beta to obtain the Beta of Text-Editing Assets:Relever the asset Beta to reflect BK’s capital structure:BK Industries, Cont.Slide 44QuestionsAn Alternative ApproachSlide 47Financing Decisions and The Cost of CapitalWhere do Firms Get Their Money?Self Financing (using internal cash flow)–Accounts for 80% (avg.) of financing–Difficult for start-up companiesExternal Financing–Borrowing from banks or issuing bonds–Sharing the business with investors by issuing stockThe Long-Term Financial Deficit (in 1999)Sources of Cash Flow (100%)Internal cash flow (retained earnings plus depreciation) 70%Long-term debt and equity 30%Uses of Cash Flow (100%)Capital spending 80%Net working capital plus other uses 20%Internal cash flowExternal cash flowFinancial deficitWhere Do Small Businesses Get Money?0 10 20 30 40 50 60OwnerFinancial CompaniesBanksFamilyOther BusinessesFraction of Funds Raised (%)Source: 1987 SBA survey of firms with less than $500,000 in assets.What Happens As Firms Get Larger?Firm SizeInformationVery small, no track record Small with growth potential Medium-sizedLarge with Track recordInside seed moneyShort-term commercial loansIntermediate-term commercial loansCommercial paperMedium-term NotesBondsPublic EquityVenture CapitalMezzanine FinancePrivate PlacementsSelfShort DebtInter-mediate DebtLong-Term DebtOutside EquitySource: FRB Report on Private Placements, Rea et. al., 1993What is the Difference Between Debt and Equity?Fixed Promised paymentsSenior to equityInterest is deductibleOnly get control rights in defaultUncertain residual cash flowsSubordinatedDividends are not deductibleComes with control rights (can vote)DebtEquityRecent Trends in FinancingThis important question is difficult to answer definitively.Book or Market values?–In general, financial economists prefer market values. Debt levels have fallen recently.–However, many corporate treasurers find book values more appealing due to the volatility of market values. These have slightly risen recently.Whether we use book or market values, debt ratios for U.S. non-financial firms have remained below 60 percent of total financing.Capital Structure:How should a firm structure the liability side of the balance sheet?Debt vs. EquityWe have seen how to do capital budgeting when the firm has debt in its capital structure.However, we have not figured out how much debt the firm should have.–Can the firm create value for shareholders through its financing decisions?In particular, should the firm load up with ‘low cost’ debt?One possible answer:It makes no difference.Assume PCM, importantly, there are no taxes, and that the firm’s investment policy is unaffected by how it finances its operations.Both Modigliani and Miller won the Nobel Prize for showing:The value of a firm with debt is in this case equal to the value of the same firm without debt. MM Proposition I.The important idea is that since the assets are the same regardless of how they are financed so are the expected cash flows and so are the asset risks (asset betas) of a “levered” and “unlevered” firm.Irrelevance Proposition IIWhat this means is that the expected return on equity rises with leverage according to: (B/S = leverage ratio -- market value of debt over market value of equity, r denotes expected return).)(DebtAssetsAssetsEquityrrSBrr WACC under IrrelevanceCost of B/S M = B/(B+S) Equity WACC0.00 0.00 9.00 9.000.50 0.33 10.50 9.001.00 0.50 12.00 9.001.50 0.60 13.50 9.002.00 0.67 15.00 9.003.00 0.75 18.00 9.00Let the expected return on the underlying assets be 9% and the cost of debt be 6%.MM Proposition II with No Corporate Taxes: Another ViewDebt-to-equity RatioCost of capital: r (%)r0rBSBWACCrSBSrSBBr )(00 BLSrrSBrr rBSBWhat About The Tax Deductibility of Interest?Interest is tax deductible (dividends are not).A valuable “debt tax shield” is created by substituting payments of interest for payments of dividends, i.e. debt financing for equity financing.Modigliani and Miller also showed that if the only change in their analysis is an acknowledgement of the US corporate tax structure, then:The value of a levered firm is: VL = VU + TcB–the value of an equivalent unlevered firm PLUS–the value of the tax shields from debt.Firm Value always rises with additional borrowing!Proposition II with TaxesWhen we take the tax deductibility of interest payments into account the equations we presented must change:and)1(cBSWACCTrBSBrBSSr ))(1(BAcASrrTSBrr Proposition IIDebt-to-equityratio (B/S)Cost of capital: r(%)r0rB)()1(00 BCLSrrTSBrr SLLCBLWACCrSBSTrSBBr  )1(Limits to The Use of DebtGiven the treatment the U. S. corporate tax code gives to interest payments versus dividend payments, firms have a big incentive to use debt financing.Under the MM assumptions with corporate taxes the argument goes to extremes and the message becomes: firms should use 100% debt financing.What other costs are associated with the use of debt? –Bankruptcy costs and/or financial distress costs!Bankruptcy CostsDirect costs:–Legal fees–Accounting fees–Costs associated with a trial (expert witnesses)Indirect costs:–Reduced effectiveness in the market.–Lower value of service contracts, warranties. Decreased willingness of suppliers to provide trade credit.–Loss of value of intangible assets--e.g., patents.Agency costs of debtWhen bankruptcy is