Corporate Finance Lecture Note Packet 2 Capital Structure Dividend Policy and Valuation B40 2302 Aswath Damodaran Aswath Damodaran 1 Capital Structure The Choices and the Trade off Neither a borrower nor a lender be Someone who obviously hated this part of corporate finance Aswath Damodaran 2 First Principles Aswath Damodaran 3 The Choices in Financing There are only two ways in which a business can make money The first is debt 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 The other is equity With equity you do get whatever cash flows are left over after you have made debt payments Aswath Damodaran 4 Global Patterns in Financing Aswath Damodaran 5 And a much greater dependence on bank loans outside the US Aswath Damodaran 6 Assessing the existing financing choices Disney Aracruz and Tata Chemicals Aswath Damodaran 7 Financing Choices across the life cycle Revenues Revenues Earnings Earnings Time External funding needs High but constrained by infrastructure High relative to firm value Moderate relative to firm value Declining as a percent of firm value Internal financing Negative or low Negative or low Low relative to funding needs High relative to funding needs More than funding needs External Financing Owner s Equity Bank Debt Venture Capital Common Stock Common stock Warrants Convertibles Debt Retire debt Repurchase stock Growth stage Stage 1 Start up Stage 2 Rapid Expansion Stage 4 Mature Growth Stage 5 Decline Financing Transitions Aswath Damodaran Accessing private equity Inital Public offering Stage 3 High Growth Seasoned equity issue Low as projects dry up Bond issues 8 The Transitional Phases The transitions that we see at firms from fully owned private businesses to venture capital from private to public and subsequent seasoned offerings are all motivated primarily by the need for capital In each transition though there are costs incurred by the existing owners Aswath Damodaran When venture capitalists enter the firm they will demand their fair share and more of the ownership of the firm to provide equity When a firm decides to go public it has to trade off the greater access to capital markets against the increased disclosure requirements that emanate from being publicly lists loss of control and the transactions costs of going public When making seasoned offerings firms have to consider issuance costs while managing their relations with equity research analysts and rat 9 Measuring a firm s financing mix The simplest measure of how much debt and equity a firm is using currently is to look at the proportion of debt in the total financing This ratio is called the debt to capital ratio Debt to Capital Ratio Debt Debt Equity Debt includes all interest bearing liabilities short term as well as long term Equity can be defined either in accounting terms as book value of equity or in market value terms based upon the current price The resulting debt ratios can be very different Aswath Damodaran 10 The Financing Mix Question In deciding to raise financing for a business is there an optimal mix of debt and equity If yes what is the trade off that lets us determine this optimal mix What are the benefits of using debt instead of equity What are the costs of using debt instead of equity If not why not Aswath Damodaran 11 Costs and Benefits of Debt Benefits of Debt Tax Benefits Adds discipline to management Costs of Debt Bankruptcy Costs Agency Costs Loss of Future Flexibility Aswath Damodaran 12 Tax Benefits of Debt When you borrow money you are allowed to deduct interest expenses from your income to arrive at taxable income This reduces your taxes When you use equity you are not allowed to deduct payments to equity such as dividends to arrive at taxable income The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment Tax benefit each year Tax Rate Interest Payment Proposition 1 Other things being equal the higher the marginal tax rate of a business the more debt it will have in its capital structure Aswath Damodaran 13 The Effects of Taxes You are comparing the debt ratios of real estate corporations which pay the corporate tax rate and real estate investment trusts which are not taxed but are required to pay 95 of their earnings as dividends to their stockholders Which of these two groups would you expect to have the higher debt ratios q The real estate corporations q The real estate investment trusts q Cannot tell without more information Aswath Damodaran 14 Debt adds discipline to management If you are managers of a firm with no debt and you generate high income and cash flows each year you tend to become complacent The complacency can lead to inefficiency and investing in poor projects There is little or no cost borne by the managers Forcing such a firm to borrow money can be an antidote to the complacency The managers now have to ensure that the investments they make will earn at least enough return to cover the interest expenses The cost of not doing so is bankruptcy and the loss of such a job Aswath Damodaran 15 Debt and Discipline Assume that you buy into this argument that debt adds discipline to management Which of the following types of companies will most benefit from debt adding this discipline q Conservatively financed very little debt privately owned businesses q Conservatively financed publicly traded companies with stocks held by millions of investors none of whom hold a large percent of the stock q Conservatively financed publicly traded companies with an activist and primarily institutional holding Aswath Damodaran 16 Bankruptcy Cost The expected bankruptcy cost is a function of two variables the probability of bankruptcy which will depend upon how uncertain you are about future cash flows the cost of going bankrupt direct costs Legal and other Deadweight Costs indirect costs Costs arising because people perceive you to be in financial trouble Proposition 2 Firms with more volatile earnings and cash flows will have higher probabilities of bankruptcy at any given level of debt and for any given level of earnings Proposition 3 Other things being equal the greater the indirect bankruptcy cost the less debt the firm can afford to use for any given level of debt Aswath Damodaran 17 Debt Bankruptcy Cost Rank the following companies on the magnitude of bankruptcy costs
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