Corporate Finance Lecture Note Packet 2 Capital Structure Dividend Policy and Valuation Aswath Damodaran B40 2302 20 Stern School of Business 1 Finding the Right Financing Mix The Capital Structure Decision 2 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate The hurdle rate should be higher for riskier projects and reflect the financing mix used owners funds equity or borrowed money debt Returns on projects should be measured based on cash flows generated and the timing of these cash flows they should also consider both positive and negative side effects of these projects Choose a financing mix that minimizes the hurdle rate and matches the assets being financed If there are not enough investments that earn the hurdle rate return the cash to stockholders The form of returns dividends and stock buybacks will depend upon the stockholders characteristics Objective Maximize the Value of the Firm 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 The equity can take different forms For very small businesses it can be owners investing their savings For slightly larger businesses it can be venture capital For publicly traded firms it is common stock The debt can also take different forms For private businesses it is usually bank loans For publicly traded firms it can take the form of bonds 4 Owner s Earnings Revenues Venture Retire Debt External Moderate Declining Internal Common Stage Low High More Accessing Inital Seasoned Bond Financing Growth Time Negative Revenues as relative Public than 35412relative issues but debt stage projects Capital financing Equity funding stock equity or private relative funding asoffering to atoChoices dry issue equity needs across the life cycle Financing Earnings Rapid Start up Mature Decline Financing Bank Common Repurchase needs constrained to percent up Warrants High low funding Transitions firmGrowth Debt Expansion value Growth of needs Stock firm by stock infrastructure value Convertibles 5 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 If not why not 6 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 7 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 8 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 9 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 The real estate corporations The real estate investment trusts Cannot tell without more information 10 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 11 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 Conservatively financed very little debt privately owned businesses Conservatively financed publicly traded companies with stocks held by millions of investors none of whom hold a large percent of the stock Conservatively financed publicly traded companies with an activist and primarily institutional holding 12 Bankruptcy Cost The expected bankruptcy cost is a function of two variables 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 the probability of bankruptcy which will depend upon how uncertain you are about future cash flows As you borrow more you increase the probability of bankruptcy and hence the expected bankruptcy cost 13 The Bankruptcy Cost Proposition Proposition 2 Other things being equal the greater the indirect bankruptcy cost and or probability of bankruptcy in the operating cashflows of the firm the less debt the firm can afford to use 14 Debt Bankruptcy Cost Rank the following companies on the magnitude of bankruptcy costs from most to least taking into account both explicit and implicit costs A Grocery Store An Airplane Manufacturer High Technology company 15 Agency Cost An agency cost arises whenever you hire someone else to do something for you It arises because your interests as the principal may deviate from those of the person you hired as the agent When you lend money to a business you are allowing the stockholders to use that money in the course of running that
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