Caps Tru Choices

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 1/30

CAPITALSTRUCTURE:THE

CHOICESANDTHETRADEOFF

“Neitheraborrowernoralenderbe”

Someonewhoobviouslyhatedthispartofcorporatefinance

Aswath Damodaran 2

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 2/30

3

Firstprinciples

Aswath Damodaran

3

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 3/30

4

TheChoicesinFinancing

Aswath Damodaran

4

¨  Thereareonlytwowaysinwhichabusinesscanmakemoney.

¤  Thefirstisdebt.Theessenceofdebtisthatyoupromisetomakefixed

paymentsinthefuture(interestpaymentsandrepayingprincipal).If

youfailtomakethosepayments,youlosecontrolofyourbusiness.

¤  Theotherisequity.Withequity,youdogetwhatevercashflowsare

leQoveraQeryouhavemadedebtpayments.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 4/30

5

GlobalPaernsinFinancing…

Aswath Damodaran

5

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 5/30

6

Andamuchgreaterdependenceonbankloans

outsidetheUS…

Aswath Damodaran

6

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 6/30

7

Assessingtheexisngfinancingchoices:Disney,

AracruzandTataChemicals

Aswath Damodaran

7

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 7/30

Stage 2

Rapid Expansion

Stage 1

Start-up

Stage 4

Mature Growth

Stage 5

Decline

Financing Choices across the life cycle

 External

Financing

Revenues

Earnings

Owner’s Equity

Bank Debt

Venture Capital

Common Stock

Debt Retire debt

Repurchase stock

 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

Low, as projects dry

up.

Common stock

Warrants

Convertibles

Stage 3

High Growth

 Negative or

low

 Negative or

lowLow, relative to

funding needs

High, relative to

funding needs

More than funding needs

Accessing private equity Inital Public offering Seasoned equity issue Bond issuesFinancing

Transitions

Growth stage

$ Revenues/

Earnings

Time

8

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 8/30

9

TheTransionalPhases..

Aswath Damodaran

9

¨  Thetransionsthatweseeatfirms–fromfullyownedprivatebusinessestoventurecapital,fromprivatetopublicandsubsequentseasonedofferingsareallmovatedprimarilybytheneedforcapital.

¨  Ineachtransion,though,therearecostsincurredbytheexisngowners:¤  Whenventurecapitalistsenterthefirm,theywilldemandtheirfair

shareandmoreoftheownershipofthefirmtoprovideequity.

¤  Whenafirmdecidestogopublic,ithastotradeoffthegreateraccesstocapitalmarketsagainsttheincreaseddisclosurerequirements(that

emanatefrombeingpubliclylists),lossofcontrolandthetransaconscostsofgoingpublic.

¤  Whenmakingseasonedofferings,firmshavetoconsiderissuancecostswhilemanagingtheirrelaonswithequityresearchanalystsandrat

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 9/30

10

Measuringafirm’sfinancingmix…

Aswath Damodaran

10

¨  Thesimplestmeasureofhowmuchdebtandequityafirmisusingcurrentlyistolookattheproporonofdebtinthetotalfinancing.Thisraoiscalledthedebttocapitalrao:

DebttoCapitalRao=Debt/(Debt+Equity)

¨  Debtincludesallinterestbearingliabilies,shorttermaswellaslongterm.

¨  Equitycanbedefinedeitherinaccounngterms(as

bookvalueofequity)orinmarketvalueterms(baseduponthecurrentprice).Theresulngdebtraoscanbeverydifferent.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 10/30

11

TheFinancingMixueson

Aswath Damodaran

11

¨  Indecidingtoraisefinancingforabusiness,isthere

anopmalmixofdebtandequity?

¤  Ifyes,whatisthetradeoffthatletsusdeterminethis

opmalmix?n  Whatarethebenefitsofusingdebtinsteadofequity?

n  Whatarethecostsofusingdebtinsteadofequity?

¤  Ifnot,whynot?

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 11/30

12

CostsandBenefitsofDebt

Aswath Damodaran

12

¨  BenefitsofDebt

¤  TaxBenefits

¤  Addsdisciplinetomanagement

¨  CostsofDebt

¤  BankruptcyCosts

¤  AgencyCosts

¤  LossofFutureFlexibility

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 12/30

13

TaxBenefitsofDebt

Aswath Damodaran

13

¨  Whenyouborrowmoney,youareallowedtodeductinterestexpensesfromyourincometoarriveattaxableincome.Thisreducesyourtaxes.Whenyouuseequity,youarenotallowedtodeductpaymentstoequity(such

asdividends)toarriveattaxableincome.¨  Thedollartaxbenefitfromtheinterestpaymentinany

yearisafunconofyourtaxrateandtheinterestpayment:¤  Taxbenefiteachyear=TaxRate*InterestPayment

¨  Proposion1:Otherthingsbeingequal,thehigherthe

marginaltaxrateofabusiness,themoredebtitwillhaveinitscapitalstructure.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 13/30

14

TheEffectsofTaxes

Aswath Damodaran

14

¨  Youarecomparingthedebtraosofrealestatecorporaons,whichpaythecorporatetaxrate,andrealestateinvestmenttrusts,whicharenottaxed,

butarerequiredtopay95%oftheirearningsasdividendstotheirstockholders.Whichofthesetwogroupswouldyouexpecttohavethehigherdebtraos?

a.  Therealestatecorporaons

b.  Therealestateinvestmenttrusts

c.  Cannottell,withoutmoreinformaon

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 14/30

15

Debtaddsdisciplinetomanagement

Aswath Damodaran

15

¨  Ifyouaremanagersofafirmwithnodebt,andyougeneratehighincomeandcashflowseachyear,youtendtobecomecomplacent.Thecomplacencycan

leadtoinefficiencyandinvesnginpoorprojects.Thereislileornocostbornebythemanagers

¨  Forcingsuchafirmtoborrowmoneycanbeanandotetothecomplacency.Themanagersnowhavetoensurethattheinvestmentstheymakewillearnatleastenoughreturntocovertheinterestexpenses.Thecostofnotdoingsoisbankruptcyandthelossofsuchajob.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 15/30

16

DebtandDiscipline

Aswath Damodaran

16

¨  Assumethatyoubuyintothisargumentthatdebtaddsdisciplinetomanagement.Whichofthefollowingtypesofcompanieswillmostbenefitfromdebtaddingthisdiscipline?

a.  Conservavelyfinanced(veryliledebt),privatelyownedbusinesses

b.  Conservavelyfinanced,publiclytradedcompanies,withstocksheldbymillionsofinvestors,noneofwhom

holdalargepercentofthestock.c.  Conservavelyfinanced,publiclytradedcompanies,

withanacvistandprimarilyinstuonalholding.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 16/30

17

BankruptcyCost

Aswath Damodaran

17

¨  Theexpectedbankruptcycostisafunconoftwovariables--

¤  theprobabilityofbankruptcy,whichwilldependuponhowuncertainyouareaboutfuturecashflows

¤  thecostofgoingbankrupt

n  directcosts:LegalandotherDeadweightCostsn  indirectcosts:Costsarisingbecausepeopleperceiveyoutobein

financialtrouble

¨  Proposion2:Firmswithmorevolaleearningsandcashflowswillhavehigherprobabiliesofbankruptcyatanygiven

levelofdebtandforanygivenlevelofearnings.¨  Proposion3:Otherthingsbeingequal,thegreaterthe

indirectbankruptcycost,thelessdebtthefirmcanaffordtouseforanygivenlevelofdebt.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 17/30

18

Debt&BankruptcyCost

Aswath Damodaran

18

¨  Rankthefollowingcompaniesonthemagnitudeof

bankruptcycostsfrommosttoleast,takinginto

accountbothexplicitandimplicitcosts:

a.  AGroceryStore

b.  AnAirplaneManufacturer

c.  HighTechnologycompany

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 18/30

19

AgencyCost

Aswath Damodaran

19

¨  Anagencycostariseswheneveryouhiresomeoneelsetodosomethingforyou.Itarisesbecauseyourinterests(astheprincipal)maydeviatefromthoseofthepersonyouhired(astheagent).

¨  Whenyoulendmoneytoabusiness,youareallowingthestockholderstousethatmoneyinthecourseofrunningthatbusiness.Stockholders

interestsaredifferentfromyourinterests,because¤  You(aslender)areinterestedingengyourmoneyback

¤  Stockholdersareinterestedinmaximizingtheirwealth

¨  Insomecases,theclashofinterestscanleadtostockholders

¤  Invesnginriskierprojectsthanyouwouldwantthemto

¤  Payingthemselveslargedividendswhenyouwouldratherhavethemkeepthecashinthebusiness.

¨  Proposion4:Otherthingsbeingequal,thegreatertheagencyproblemsassociatedwithlendingtoafirm,thelessdebtthefirmcanaffordtouse.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 19/30

20

DebtandAgencyCosts

Aswath Damodaran

20

¨  Assumethatyouareabank.Whichofthefollowing

businesseswouldyouperceivethegreatestagency

costs?

a.  ALargetechnologyfirm

b.  ALargeRegulatedElectricUlity

¨  Why?

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 20/30

21

Lossoffuturefinancingflexibility

Aswath Damodaran

21

¨  Whenafirmborrowsuptoitscapacity,itlosesthe

flexibilityoffinancingfutureprojectswithdebt.

¨  Proposion5:Otherthingsremainingequal,the

moreuncertainafirmisaboutitsfuturefinancing

requirementsandprojects,thelessdebtthefirm

willuseforfinancingcurrentprojects.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 21/30

22

Whatmanagersconsiderimportantindeciding

onhowmuchdebttocarry...

Aswath Damodaran

22

¨  AsurveyofChiefFinancialOfficersoflargeU.S.companiesprovidedthefollowingranking(frommostimportanttoleastimportant)forthefactorsthattheyconsideredimportantinthefinancingdecisions

Factor Ranking(0-5)

1.Maintainfinancialflexibility 4.55

2.Ensurelong-termsurvival 4.55

3.MaintainPredictableSourceofFunds 4.05

4.MaximizeStockPrice 3.995.Maintainfinancialindependence 3.88

6.Maintainhighdebtrang 3.56

7.Maintaincomparabilitywithpeergroup 2.47

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 22/30

23

Debt:Summarizingthetradeoff

Aswath Damodaran

23

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 23/30

24

TheTradeoffforthreecompanies..

Aswath Damodaran

24

 Item Disney Aracruz Tata Chemicals

Tax benefits Significant. The firm

has a marginal tax

rate of 38%. It doeshave large

depreciation tax

shields.

Significant. The firm

has a marginal tax

rate of 34%, as well.It does not have very

much in noninterest

tax shields.

Significant. The firm

has a 33.99% tax

rates It does havesignificant non-

interest tax shields in

the form of 

depreciation.

Added

discipline

Benefits will be high,

because managers are

not large

stockholders.

Benefits are smaller,

because the voting

shares are closely

held by insiders.

Since the Tata family

runs the firm, the

benefits from added

discipline are small.

Bankruptcycosts

Movie andbroadcasting

businesses have

volatile earnings.

Direct costs of 

bankruptcy are likelyto be small, but

indirect costs can be

significant.

Variability in paperprices makes earnings

volatile. Direct and

indirect costs of 

bankruptcy likely to

be moderate, sinceassets are marketable

(timber, paper plants)

Firm is mature, withfairly stable earnings

and cash flows from

its chemicals and

fertilizer business.

Indirect bankruptcycosts should be low,

since physical assets

are marketable.

Agency costs High. Althoughtheme park assets are

tangible and fairly

liquid, is much more

difficult to monitor

movie andbroadcasting

businesses.

Low. Assets aretangible and liquid.

Biggest concern isthat debt may be

utilized in other

(riskier) Tata

companies.

Flexibility

needs

Low in theme park

business but high in

media businessesbecause technological

change makes future

investment uncertain.

Low. Business is

mature and

investment needs arewell established.

Low. Tata Chemicals

is a mature company

with establishedreinvestment needs.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 24/30

25

ApplicaonTest:Wouldyouexpectyourfirmto

gainorlosefromusingalotofdebt?

Aswath Damodaran

25

¨  Considering,foryourfirm,

¤  Thepotenaltaxbenefitsofborrowing

¤  Thebenefitsofusingdebtasadisciplinarymechanism

¤  Thepotenalforexpectedbankruptcycosts¤  Thepotenalforagencycosts

¤  Theneedforfinancialflexibility

¨  Wouldyouexpectyourfirmtohaveahighdebtraooralowdebtrao?

¨  Doesthefirm’scurrentdebtraomeetyourexpectaons?

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 25/30

26

AHypothecalScenario

Aswath Damodaran

26

Assumethatyouliveinaworldwhere

(a)Therearenotaxes

(b)Managershavestockholderinterestsatheartanddo

what’sbestforstockholders.(c)Nofirmevergoesbankrupt

(d)Equityinvestorsarehonestwithlenders;thereisno

subterfugeoraempttofindloopholesinloanagreements.

(e)Firmsknowtheirfuturefinancingneedswithcertainty¨  Whathappenstothetradeoffbetweendebtand

equity?Howmuchshouldafirmborrow?

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 26/30

27

TheMiller-ModiglianiTheorem

Aswath Damodaran

27

¨  Inanenvironment,wheretherearenotaxes,defaultriskoragencycosts,

capitalstructureisirrelevant.

¨  IftheMillerModiglianitheoremholds:

¤  Afirm'svaluewillbedeterminedthequalityofitsinvestmentsandnot

byitsfinancingmix.

¤  Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm

increasesitsleverage,thecostofequitywillincreasejustenoughto

offsetanygainstotheleverage.

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 27/30

28

Whatdofirmslookatinfinancing?

Aswath Damodaran

28

¨  Therearesomewhoarguethatfirmsfollowafinancinghierarchy,withretainedearningsbeingthemostpreferredchoiceforfinancing,followedbydebtandthatnewequityistheleastpreferredchoice.Inparcular,

¤  Managersvalueflexibility.Managersvaluebeingabletousecapital(onnewinvestmentsorassets)withoutrestriconsonthatuseorhavingtoexplainitsusetoothers.

¤  Managersvaluecontrol.Managerslikebeingabletomaintaincontroloftheirbusinesses.

¨  Withflexibilityandcontrolbeingkeyfactors:¤  Wouldyouratheruseinternalfinancing(retainedearnings)or

externalfinancing?

¤  Withexternalfinancing,wouldyouratherusedebtorequity?

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 28/30

29

Preferencerankingslong-termfinance:Results

ofasurvey

Aswath Damodaran

29

Ranking Source Score1 Retained Earnings 5.612 Straight Debt 4.883 Convertible Debt 3.024 External Common Equity 2.425 Straight Preferred Stock 2.226 Convertible Preferred 1.72

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 29/30

30

Andtheunsurprisingconsequences..

Aswath Damodaran

30

7/29/2019 Caps Tru Choices

http://slidepdf.com/reader/full/caps-tru-choices 30/30

31

FinancingChoices

Aswath Damodaran

31

¨  YouarereadingtheWallStreetJournalandnocea

tombstoneadforacompany,offeringtosell

converblepreferredstock.Whatwouldyou

hypothesizeaboutthehealthofthecompanyissuingthesesecuries?

a.  Nothing

b.  Healthierthantheaveragefirm

c.  Inmuchmorefinancialtroublethantheaverage

firm