Caps Tru Choices

7/29/2019 Caps Tru Choices

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CAPITALSTRUCTURE:THE

CHOICESANDTHETRADEOFF

“Neitheraborrowernoralenderbe”

Someonewhoobviouslyhatedthispartofcorporatefinance

Aswath Damodaran 2



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Firstprinciples

Aswath Damodaran

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TheChoicesinFinancing

Aswath Damodaran

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¨ Thereareonlytwowaysinwhichabusinesscanmakemoney.

¤ Thefirstisdebt.Theessenceofdebtisthatyoupromisetomakefixed

paymentsinthefuture(interestpaymentsandrepayingprincipal).If

youfailtomakethosepayments,youlosecontrolofyourbusiness.

¤ Theotherisequity.Withequity,youdogetwhatevercashflowsare

leQoveraQeryouhavemadedebtpayments.



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GlobalPaernsinFinancing…

Aswath Damodaran

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Andamuchgreaterdependenceonbankloans

outsidetheUS…

Aswath Damodaran

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Assessingtheexisngfinancingchoices:Disney,

AracruzandTataChemicals

Aswath Damodaran

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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

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TheTransionalPhases..

Aswath Damodaran

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¨ Thetransionsthatweseeatfirms–fromfullyownedprivatebusinessestoventurecapital,fromprivatetopublicandsubsequentseasonedofferingsareallmovatedprimarilybytheneedforcapital.

¨ Ineachtransion,though,therearecostsincurredbytheexisngowners:¤ Whenventurecapitalistsenterthefirm,theywilldemandtheirfair

shareandmoreoftheownershipofthefirmtoprovideequity.

¤ Whenafirmdecidestogopublic,ithastotradeoffthegreateraccesstocapitalmarketsagainsttheincreaseddisclosurerequirements(that

emanatefrombeingpubliclylists),lossofcontrolandthetransaconscostsofgoingpublic.

¤ Whenmakingseasonedofferings,firmshavetoconsiderissuancecostswhilemanagingtheirrelaonswithequityresearchanalystsandrat



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Measuringafirm’sfinancingmix…

Aswath Damodaran

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¨ Thesimplestmeasureofhowmuchdebtandequityafirmisusingcurrentlyistolookattheproporonofdebtinthetotalfinancing.Thisraoiscalledthedebttocapitalrao:

DebttoCapitalRao=Debt/(Debt+Equity)

¨ Debtincludesallinterestbearingliabilies,shorttermaswellaslongterm.

¨ Equitycanbedefinedeitherinaccounngterms(as

bookvalueofequity)orinmarketvalueterms(baseduponthecurrentprice).Theresulngdebtraoscanbeverydifferent.



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TheFinancingMixueson

Aswath Damodaran

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¨ Indecidingtoraisefinancingforabusiness,isthere

anopmalmixofdebtandequity?

¤ Ifyes,whatisthetradeoffthatletsusdeterminethis

opmalmix?n Whatarethebenefitsofusingdebtinsteadofequity?

n Whatarethecostsofusingdebtinsteadofequity?

¤ Ifnot,whynot?



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CostsandBenefitsofDebt

Aswath Damodaran

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¨ BenefitsofDebt

¤ TaxBenefits

¤ Addsdisciplinetomanagement

¨ CostsofDebt

¤ BankruptcyCosts

¤ AgencyCosts

¤ LossofFutureFlexibility



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TaxBenefitsofDebt

Aswath Damodaran

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

asdividends)toarriveattaxableincome.¨ Thedollartaxbenefitfromtheinterestpaymentinany

yearisafunconofyourtaxrateandtheinterestpayment:¤ Taxbenefiteachyear=TaxRate*InterestPayment

¨ Proposion1:Otherthingsbeingequal,thehigherthe

marginaltaxrateofabusiness,themoredebtitwillhaveinitscapitalstructure.



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TheEffectsofTaxes

Aswath Damodaran

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¨ Youarecomparingthedebtraosofrealestatecorporaons,whichpaythecorporatetaxrate,andrealestateinvestmenttrusts,whicharenottaxed,

butarerequiredtopay95%oftheirearningsasdividendstotheirstockholders.Whichofthesetwogroupswouldyouexpecttohavethehigherdebtraos?

a. Therealestatecorporaons

b. Therealestateinvestmenttrusts

c. Cannottell,withoutmoreinformaon



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Debtaddsdisciplinetomanagement

Aswath Damodaran

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¨ Ifyouaremanagersofafirmwithnodebt,andyougeneratehighincomeandcashflowseachyear,youtendtobecomecomplacent.Thecomplacencycan

leadtoinefficiencyandinvesnginpoorprojects.Thereislileornocostbornebythemanagers

¨ Forcingsuchafirmtoborrowmoneycanbeanandotetothecomplacency.Themanagersnowhavetoensurethattheinvestmentstheymakewillearnatleastenoughreturntocovertheinterestexpenses.Thecostofnotdoingsoisbankruptcyandthelossofsuchajob.



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DebtandDiscipline

Aswath Damodaran

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¨ Assumethatyoubuyintothisargumentthatdebtaddsdisciplinetomanagement.Whichofthefollowingtypesofcompanieswillmostbenefitfromdebtaddingthisdiscipline?

a. Conservavelyfinanced(veryliledebt),privatelyownedbusinesses

b. Conservavelyfinanced,publiclytradedcompanies,withstocksheldbymillionsofinvestors,noneofwhom

holdalargepercentofthestock.c. Conservavelyfinanced,publiclytradedcompanies,

withanacvistandprimarilyinstuonalholding.



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BankruptcyCost

Aswath Damodaran

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¨ Theexpectedbankruptcycostisafunconoftwovariables--

¤ theprobabilityofbankruptcy,whichwilldependuponhowuncertainyouareaboutfuturecashflows

¤ thecostofgoingbankrupt

n directcosts:LegalandotherDeadweightCostsn indirectcosts:Costsarisingbecausepeopleperceiveyoutobein

financialtrouble

¨ Proposion2:Firmswithmorevolaleearningsandcashflowswillhavehigherprobabiliesofbankruptcyatanygiven

levelofdebtandforanygivenlevelofearnings.¨ Proposion3:Otherthingsbeingequal,thegreaterthe

indirectbankruptcycost,thelessdebtthefirmcanaffordtouseforanygivenlevelofdebt.



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Debt&BankruptcyCost

Aswath Damodaran

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¨ Rankthefollowingcompaniesonthemagnitudeof

bankruptcycostsfrommosttoleast,takinginto

accountbothexplicitandimplicitcosts:

a. AGroceryStore

b. AnAirplaneManufacturer

c. HighTechnologycompany



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AgencyCost

Aswath Damodaran

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

¨ Whenyoulendmoneytoabusiness,youareallowingthestockholderstousethatmoneyinthecourseofrunningthatbusiness.Stockholders

interestsaredifferentfromyourinterests,because¤ You(aslender)areinterestedingengyourmoneyback

¤ Stockholdersareinterestedinmaximizingtheirwealth

¨ Insomecases,theclashofinterestscanleadtostockholders

¤ Invesnginriskierprojectsthanyouwouldwantthemto

¤ Payingthemselveslargedividendswhenyouwouldratherhavethemkeepthecashinthebusiness.

¨ Proposion4:Otherthingsbeingequal,thegreatertheagencyproblemsassociatedwithlendingtoafirm,thelessdebtthefirmcanaffordtouse.



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DebtandAgencyCosts

Aswath Damodaran

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¨ Assumethatyouareabank.Whichofthefollowing

businesseswouldyouperceivethegreatestagency

costs?

a. ALargetechnologyfirm

b. ALargeRegulatedElectricUlity

¨ Why?



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Lossoffuturefinancingflexibility

Aswath Damodaran

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¨ Whenafirmborrowsuptoitscapacity,itlosesthe

flexibilityoffinancingfutureprojectswithdebt.

¨ Proposion5:Otherthingsremainingequal,the

moreuncertainafirmisaboutitsfuturefinancing

requirementsandprojects,thelessdebtthefirm

willuseforfinancingcurrentprojects.



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Whatmanagersconsiderimportantindeciding

onhowmuchdebttocarry...

Aswath Damodaran

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¨ 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



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Debt:Summarizingthetradeoff

Aswath Damodaran

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TheTradeoffforthreecompanies..

Aswath Damodaran

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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.



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ApplicaonTest:Wouldyouexpectyourfirmto

gainorlosefromusingalotofdebt?

Aswath Damodaran

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¨ Considering,foryourfirm,

¤ Thepotenaltaxbenefitsofborrowing

¤ Thebenefitsofusingdebtasadisciplinarymechanism

¤ Thepotenalforexpectedbankruptcycosts¤ Thepotenalforagencycosts

¤ Theneedforfinancialflexibility

¨ Wouldyouexpectyourfirmtohaveahighdebtraooralowdebtrao?

¨ Doesthefirm’scurrentdebtraomeetyourexpectaons?



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AHypothecalScenario

Aswath Damodaran

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Assumethatyouliveinaworldwhere

(a)Therearenotaxes

(b)Managershavestockholderinterestsatheartanddo

what’sbestforstockholders.(c)Nofirmevergoesbankrupt

(d)Equityinvestorsarehonestwithlenders;thereisno

subterfugeoraempttofindloopholesinloanagreements.

(e)Firmsknowtheirfuturefinancingneedswithcertainty¨ Whathappenstothetradeoffbetweendebtand

equity?Howmuchshouldafirmborrow?



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TheMiller-ModiglianiTheorem

Aswath Damodaran

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¨ Inanenvironment,wheretherearenotaxes,defaultriskoragencycosts,

capitalstructureisirrelevant.

¨ IftheMillerModiglianitheoremholds:

¤ Afirm'svaluewillbedeterminedthequalityofitsinvestmentsandnot

byitsfinancingmix.

¤ Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm

increasesitsleverage,thecostofequitywillincreasejustenoughto

offsetanygainstotheleverage.



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Whatdofirmslookatinfinancing?

Aswath Damodaran

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¨ Therearesomewhoarguethatfirmsfollowafinancinghierarchy,withretainedearningsbeingthemostpreferredchoiceforfinancing,followedbydebtandthatnewequityistheleastpreferredchoice.Inparcular,

¤ Managersvalueflexibility.Managersvaluebeingabletousecapital(onnewinvestmentsorassets)withoutrestriconsonthatuseorhavingtoexplainitsusetoothers.

¤ Managersvaluecontrol.Managerslikebeingabletomaintaincontroloftheirbusinesses.

¨ Withflexibilityandcontrolbeingkeyfactors:¤ Wouldyouratheruseinternalfinancing(retainedearnings)or

externalfinancing?

¤ Withexternalfinancing,wouldyouratherusedebtorequity?



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Preferencerankingslong-termfinance:Results

ofasurvey

Aswath Damodaran

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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



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Andtheunsurprisingconsequences..

Aswath Damodaran

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FinancingChoices

Aswath Damodaran

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¨ YouarereadingtheWallStreetJournalandnocea

tombstoneadforacompany,offeringtosell

converblepreferredstock.Whatwouldyou

hypothesizeaboutthehealthofthecompanyissuingthesesecuries?

a. Nothing

b. Healthierthantheaveragefirm

c. Inmuchmorefinancialtroublethantheaverage

firm

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