Financing Decisions and The Cost of CapitalWhere do Firms Get Money?Where Do Small Businesses Get Money?A Life Cycle of FinancingThe Capital Structure Question:One possible answer: It makes no difference!Irrelevance Proposition IIMM Proposition IISlide 9What About The Tax Deductibility of Interest?Proposition II with TaxesSlide 12Limits to The Use of DebtBankruptcy CostsAgency Costs of DebtUnder-investment ProblemDisciplinary Power of DebtSlide 18Choosing an Amount of DebtLeverage Ratios for Selected IndustriesFinancing DecisionsExampleRalph’s DilemmaRalph’s Dilemma cont…Slide 25Slide 26ValuationsAn Alternative ValuationAPV Versus WACCAPV – ExampleThe Alternative ApproachFinancing Decisions and The Cost of CapitalWhere do Firms Get Money?Self Financing (using internal cash flow)Accounts for 80% (avg.) of financing in the U.S.Difficult for start-up companiesExternal FinancingBorrowing from banks or issuing bondsSharing ownership by issuing stockNet new issues of these securities accounts for the other 20% on averageAbout 80% of what is raised or generated and retained is used for capital spending and the rest for working capital and “other” usesWhere Do Small Businesses Get Money?Source: 1987 SBA survey of firms with less than $500,000 in assets.A Life Cycle of FinancingFirm Size/AgeInformationVery 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., 1993The Capital Structure Question:How should a firm structure the left hand side of its balance sheet?Debt vs. Equity – the choice for our purposes.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 use.Can the firm change shareholder value through its financing decisions?In particular, should the firm load up with ‘low cost’ debt?One possible answer: It makes no difference!Assume PCM: there are no differential taxes and the firm’s investment policy is unaffected by how it finances its operations.Both Modigliani and Miller won a Nobel Prize for showing:The value of a firm with debt is, under these circumstances, equal to the value of the same firm without debt. MM Proposition I.Since the assets are the same, regardless of how they are financed, so are the expected cash flows and the asset risks (asset betas) of equivalent “levered” and “unlevered” firms.Irrelevance Proposition IIWhat this means is that the expected return on equity rises with leverage according to: (where, B/S = leverage ratio -- market value of debt over market value of equity, r denotes expected return or appropriate discount rate).I will try to use r0 not rA for consistency with the text.)(DebtAssetsAssetsEquityrrSBrr MM Proposition IIWhy does the expected return on equity rise?The SML tells us that the expected return on an asset changes only when what characteristic of the asset changes?The beta of a portfolio is the weighted sum of the individual betas:Rearrange this to find: BSSB00BSBSBBSS0MM 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 generated by the use of debt.Firm Value rises with additional borrowing! Why?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(00 BcSrrTSBrr ))(1(00 BcSTSBProposition IIDebt-to-equityratio (B/S)Cost of capital: r(%)r0rB)()1(00 BCLSrrTSBrr SLLCBLWACCrSBSTrSBBr  )1()(00 BLSrrSBrr 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 costs are associated with the use of debt? Bankruptcy costs and/or costs of financial distress!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 likely incentives may be altered. Example (Over-investment):Big Trouble Corp. (BTC) owes its creditors $5 million, due in six months. BTC has liquidated its assets because it could not operate profitably. Its remaining asset is $1 million cash.Big Bill, the lone shareholder and general manager is considering two possible investments. •(1) Buy six month T-bills to earn 3% interest.•(2) Go to Vegas and wager the entire $1 million on a single spin of the roulette wheel.Why might Bill consider the second “investment”?Would he have considered it in the absence of high leverage?Under-investment ProblemSlight Trouble Corp. (STC) has a small but significant chance of bankruptcy in the next few years. Its debt is trading far below par.Managers are evaluating an investment project that will cost $1 million to undertake. The alternative is to pay $1 million out as dividends.While the NPV of the project is positive it may be that the shareholders are better off with the dividend than