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Aswath Damodaran / Expanded and Edited by Del Hawley1 Brief Overview of Debt and Equity.

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Presentation on theme: "Aswath Damodaran / Expanded and Edited by Del Hawley1 Brief Overview of Debt and Equity."— Presentation transcript:

1 Aswath Damodaran / Expanded and Edited by Del Hawley1 Brief Overview of Debt and Equity

2 Aswath Damodaran / Expanded and Edited by Del Hawley2 The Only Two Choices for Financing Debt (Leverage) 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. Equity With equity, you do get whatever cash flows are left over after you have made debt payments.

3 Aswath Damodaran / Expanded and Edited by Del Hawley3 Debt versus Equity DebtEquity Fixed ClaimResidual Claim High Priority on Cash Flows Lowest Priority on Cash Flows Interest is Tax DeductibleNo Tax Break on Dividends Fixed MaturityInfinite Life

4 Aswath Damodaran / Expanded and Edited by Del Hawley4 When Is It Debt? Ask 3 Questions: 1.Is the cashflow claim created by this financing a fixed commitment or a residual claim? 2.Is the commitment tax-deductible? 3.If you fail to uphold the commitment, do you lose control of the business? If all three answers are “Yes”, it’s debt. Otherwise, it’s equity or a hybrid.

5 Aswath Damodaran / Expanded and Edited by Del Hawley5 Cost of Debt Debt is always the least costly form of financing. WHY?

6 Aswath Damodaran / Expanded and Edited by Del Hawley6 Cost of Debt vs. Equity E(R) Rf β Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be lower. Equity Debt

7 Aswath Damodaran / Expanded and Edited by Del Hawley7 Debt versus Equity FactorDebtEquity CostLowestHighest Risk to the Firm High: Bankruptcy and volatility of cashflows Low Impact on Flexibility High: Major restrictions on decision making Low: Few restrictions on decision making Impact on Control Low, unless firm is in bankruptcy Potentially High: Many owners

8 Aswath Damodaran / Expanded and Edited by Del Hawley8 The Choices Equity can take different forms: Small business owners investing their savings Venture capital for startups Common stock for corporations Debt can also take different forms For private businesses, it is usually bank loans For publicly traded firms, it is more likely to be debentures (bonds) for long-term debt and commercial paper for short-term debt

9 Aswath Damodaran / Expanded and Edited by Del Hawley9 Compare Advantages and Disadvantages of Debt Advantages of Debt Interest is tax-subsidized  Low cost Increases upside variability of cashflows to equity Adds discipline to management Disadvantages of Debt Possibility of bankruptcy/financial distress Increases downside variability of cashflows to equity Agency costs are incurred Loss of future flexibility

10 Aswath Damodaran / Expanded and Edited by Del Hawley10 What Does Leverage Mean? Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.

11 Aswath Damodaran / Expanded and Edited by Del Hawley11 What Does Leverage Mean? In financial leverage, the fulcrum is the fixed cost of the debt financing. The small force is variability of operating income. The large force is the variability of cashflows to shareholders (EPS)

12 Aswath Damodaran / Expanded and Edited by Del Hawley12 What Does Leverage Mean? The larger the fixed interest payments… The more a small change in operating profit… Will be amplified into a larger change in EPS

13 Aswath Damodaran / Expanded and Edited by Del Hawley13 What managers consider important in deciding on how much debt to carry... A survey of Chief Financial Officers of large U.S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions FactorRanking (0-5) 1. Maintain financial flexibility Ensure long-term survival Maintain Predictable Source of Funds Maximize Stock Price Maintain financial independence Maintain high debt rating Maintain comparability with peer group2.47

14 Aswath Damodaran / Expanded and Edited by Del Hawley14 Why does the Capital Structure Mix matter? Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. If the cash flows to the firm are held constant and the cost of capital is minimized, the value of the firm will be maximized. So, if capital structure changes do not affect the cost of capital, then capital structure is irrelevant since it will not affect firm value.

15 Aswath Damodaran / Expanded and Edited by Del Hawley15 The Most Realistic View of Capital Structure…

16 Aswath Damodaran / Expanded and Edited by Del Hawley16 The Most Realistic View of Capital Structure… The tax advantage of debt would be progressively offset by the rising potential for bankruptcy and the resulting financial distress costs, and also by the rising agency costs. The result would be that the WACC would fall as debt went from zero to some larger amount, but would eventually reach a minimum and then start to climb. Thus, there would be an optimal capital structure where the WACC is minimized. This would be less that 100% debt.


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