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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
8
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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