Aswath Damodaran
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CORPORATEFINANCE
LECTURENOTEPACKET2
CAPITALSTRUCTURE,DIVIDEND
POLICYANDVALUATION
AswathDamodaran
Spring2017
Aswath Damodaran
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CAPITALSTRUCTURE:THE
CHOICESANDTHETRADEOFF
“Neitheraborrowernoralenderbe”
Someonewhoobviouslyhatedthispartofcorporatefinance
Firstprinciples
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TheChoicesinFinancing
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Thereareonlytwowaysinwhichabusinesscanraisemoney.
¤ Thefirstisdebt.Theessenceofdebtisthatyoupromisetomakefixed
paymentsinthefuture(interestpaymentsandrepayingprincipal).If
youfailtomakethosepayments,youlosecontrolofyourbusiness.
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Theotherisequity.Withequity,youdogetwhatevercashflowsare
leftoverafteryouhavemadedebtpayments.
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GlobalPatternsinFinancing…
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Andamuchgreaterdependenceonbankloans
outsidetheUS…
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Assessingtheexistingfinancingchoices:Disney,
Vale,TataMotors,Baidu &Bookscape
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TheTransitionalPhases..
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Thetransitionsthatweseeatfirms– fromfullyowned
privatebusinessestoventurecapital,fromprivatetopublic
andsubsequentseasonedofferingsareallmotivated
primarilybytheneedforcapital.
Ineachtransition,though,therearecostsincurredbythe
existingowners:
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Whenventurecapitalistsenterthefirm,theywilldemandtheirfair
shareandmoreoftheownershipofthefirmtoprovideequity.
Whenafirmdecidestogopublic,ithastotradeoffthegreateraccess
tocapitalmarketsagainsttheincreaseddisclosurerequirements(that
emanatefrombeingpubliclylists),lossofcontrolandthetransactions
costsofgoingpublic.
Whenmakingseasonedofferings,firmshavetoconsiderissuance
costswhilemanagingtheirrelationswithequityresearchanalystsand
rat
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Measuringafirm’sfinancingmix…
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Thesimplestmeasureofhowmuchdebtandequityafirmis
usingcurrentlyistolookattheproportionofdebtinthetotal
financing.Thisratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswell
aslongterm.Itshouldalsoincludeothercommitmentsthat
meetthecriteriafordebt:contractuallypre-setpayments
thathavetobemade,nomatterwhatthefirm’sfinancial
standing.
Equitycanbedefinedeitherinaccountingterms(asbook
valueofequity)orinmarketvalueterms(baseduponthe
currentprice).Theresultingdebtratioscanbeverydifferent.
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TheFinancingMixQuestion
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Indecidingtoraisefinancingforabusiness,isthere
anoptimalmixofdebtandequity?
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Ifyes,whatisthetradeoffthatletsusdeterminethis
optimalmix?
n
n
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Whatarethebenefitsofusingdebtinsteadofequity?
Whatarethecostsofusingdebtinsteadofequity?
Ifnot,whynot?
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TheIllusoryBenefitsofDebt
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Atfirstsight,thebenefitofdebtseemsobvious.Thecost
ofdebtislowerthanthecostofequity.
Thatbenefitisanillusion,though,becausedebtis
cheaperthanequityforasimplereason.Thelendergets
bothfirstclaimonthecashflowsandacontractually
pre-setcashflow.Theequityinvestorislastinlineand
hastodemandahigherrateofreturnthanthelender
does.
Byborrowingmoneyatalowerrate,youarenotmaking
abusinessmorevaluable,butjustmovingtherisk
around.
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CostsandBenefitsofDebt
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BenefitsofDebt
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TaxBenefits:Thetaxcodeistiltedinfavorofdebt,withinterest
paymentsbeingtaxdeductibleinmostpartsoftheworld,while
cashflowstoequityarenot.
Addsdisciplinetomanagement:Whenmanagersaresloppyin
theirprojectchoices,borrowingmoneymaymakethemlessso.
CostsofDebt
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BankruptcyCosts:Borrowingmoneywillincreaseyourexpected
probabilityandcostofbankruptcy.
AgencyCosts:What’sgoodforstockholdersisnotalwayswhat’s
goodforlendersandthatcreatesfrictionandcosts.
LossofFutureFlexibility:Usingupdebtcapacitytodaywillmean
thatyouwillnotbeabletodrawonitinthefuture.
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TaxBenefitsofDebt
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Whenyouborrowmoney,youareallowedtodeductinterest
expensesfromyourincometoarriveattaxableincome.This
reducesyourtaxes.Whenyouuseequity,youarenot
allowedtodeductpaymentstoequity(suchasdividends)to
arriveattaxableincome.
Thedollartaxbenefitfromtheinterestpaymentinanyyearis
afunctionofyourtaxrateandtheinterestpayment:
Taxbenefiteachyear=TaxRate*InterestPayment
Thecaveatisthatyouneedtohavetheincometocoverinterest
paymentstogetthistaxbenefit.
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Proposition1:Otherthingsbeingequal,thehigherthe
marginaltaxrateofabusiness,themoredebtitwillhavein
itscapitalstructure.
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TheEffectsofTaxes
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a.
b.
c.
Youarecomparingthedebtratiosofrealestate
corporations,whichpaythecorporatetaxrate,and
realestateinvestmenttrusts,whicharenottaxed,
butarerequiredtopay95%oftheirearningsas
dividendstotheirstockholders.Whichofthesetwo
groupswouldyouexpecttohavethehigherdebt
ratios?
Therealestatecorporations
Therealestateinvestmenttrusts
Cannottell,withoutmoreinformation
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Debtaddsdisciplinetomanagement
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Ifyouaremanagersofafirmwithnodebt,andyou
generatehighincomeandcashflowseachyear,you
tendtobecomecomplacent.Thecomplacencycan
leadtoinefficiencyandinvestinginpoorprojects.
Thereislittleornocostbornebythemanagers
Forcingsuchafirmtoborrowmoneycanbean
antidotetothecomplacency.Themanagersnow
havetoensurethattheinvestmentstheymakewill
earnatleastenoughreturntocovertheinterest
expenses.Thecostofnotdoingsoisbankruptcyand
thelossofsuchajob.
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DebtandDiscipline
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a.
b.
c.
Assumethatyoubuyintothisargumentthatdebtadds
disciplinetomanagement.Whichofthefollowingtypes
ofcompanieswillmostbenefitfromdebtaddingthis
discipline?
Conservativelyfinanced(verylittledebt),privately
ownedbusinesses
Conservativelyfinanced,publiclytradedcompanies,
withstocksheldbymillionsofinvestors,noneofwhom
holdalargepercentofthestock.
Conservativelyfinanced,publiclytradedcompanies,
withanactivistandprimarilyinstitutionalholding.
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BankruptcyCost
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Theexpectedbankruptcycostisafunctionoftwovariables-¤
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theprobabilityofbankruptcy,whichwilldependuponhowuncertain
youareaboutfuturecashflows
thecostofgoingbankrupt
n directcosts:LegalandotherDeadweightCosts
n indirectcosts:Costsarisingbecausepeopleperceiveyoutobein
financialtrouble
Proposition2:Firmswithmorevolatileearningsandcash
flowswillhavehigherprobabilitiesofbankruptcyatanygiven
levelofdebtandforanygivenlevelofearnings.
Proposition3:Otherthingsbeingequal,thegreaterthe
indirectbankruptcycost,thelessdebtthefirmcanaffordto
useforanygivenlevelofdebt.
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Debt&BankruptcyCost
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a.
b.
c.
Rankthefollowingcompaniesonthemagnitudeof
bankruptcycostsfrommosttoleast,takinginto
accountbothexplicitandimplicitcosts:
AGroceryStore
AnAirplaneManufacturer
HighTechnologycompany
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AgencyCost
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Anagencycostariseswheneveryouhiresomeoneelsetodosomething
foryou.Itarisesbecauseyourinterests(astheprincipal)maydeviatefrom
thoseofthepersonyouhired(astheagent).
Whenyoulendmoneytoabusiness,youareallowingthestockholdersto
usethatmoneyinthecourseofrunningthatbusiness.Stockholders
interestsaredifferentfromyourinterests,because
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Insomecases,theclashofinterestscanleadtostockholders
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You(aslender)areinterestedingettingyourmoneyback
Stockholdersareinterestedinmaximizingtheirwealth
Investinginriskierprojectsthanyouwouldwantthemto
Payingthemselveslargedividendswhenyouwouldratherhavethemkeepthecash
inthebusiness.
Proposition4:Otherthingsbeingequal,thegreatertheagencyproblems
associatedwithlendingtoafirm,thelessdebtthefirmcanaffordtouse.
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DebtandAgencyCosts
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a.
b.
c.
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Assumethatyouareabank.Whichofthefollowing
businesseswouldyouperceivethegreatestagency
costs?
ATechnologyfirm
ALargeRegulatedElectricUtility
ARealEstateCorporation
Why?
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Lossoffuturefinancingflexibility
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Whenafirmborrowsuptoitscapacity,itlosesthe
flexibilityoffinancingfutureprojectswithdebt.
Thus,ifthefirmisfacedwithanunexpected
investmentopportunityorabusinessshortfall,itwill
notbeabletodrawondebtcapacity,ifithasalread
useditup.
Proposition5:Otherthingsremainingequal,the
moreuncertainafirmisaboutitsfuturefinancing
requirementsandprojects,thelessdebtthefirmwill
useforfinancingcurrentprojects.
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Whatmanagersconsiderimportantindeciding
onhowmuchdebttocarry...
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AsurveyofChiefFinancialOfficersoflargeU.S.
companiesprovidedthefollowingranking(frommost
importanttoleastimportant)forthefactorsthatthey
consideredimportantinthefinancingdecisions
Factor
1.Maintainfinancialflexibility
2.Ensurelong-termsurvival
3.MaintainPredictableSourceofFunds
4.MaximizeStockPrice
5.Maintainfinancialindependence
6.Maintainhighdebtrating
7.Maintaincomparabilitywithpeergroup
Aswath Damodaran
Ranking(0-5)
4.55
4.55
4.05
3.99
3.88
3.56
2.47
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Debt:Summarizingthetradeoff
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