1. IBM

2. Capital Structure: How Much Debt?
IBM
Capital Structure: How Much Debt?
Prof. Ian Giddy
New York University

3. First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
This is the second component of corporate finance. Firms have to choose both the right financing mix and right type of financing for their needs.

4. What determines the optimal mix of debt and equity for a company?
The Agenda
What determines the optimal mix of debt and equity for a company?
How does altering the mix of debt and equity affect the value of a company?
What is the right kind of debt for a company?
These are the basic questions that we will try to answer in this part of the discussion.

5. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING
RISK MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT
EQUITY
M&A
TOOLS

6. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING
RISK MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT
EQUITY
M&A
TOOLS

7. Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING
RISK MGT
PORTFOLIO
MEASUREMENT
CAPITAL
DEBT
EQUITY
M&A
TOOLS

8. IBM: How Much Debt?
Source: biz.yahoo.com

9. IBM: How Much Debt is Right?
Source: morningstar.com

10. IBM: Changes in Debt Mix
Source: morningstar.com

11. Getting the Financing Right Step 1: The Proportion of Equity & Debt
Achieve lowest weighted average cost of capital
May also affect the business side
Debt
Equity

12. Getting the Financing Right Step 2: The Kind of Equity & Debt
Short term? Long term?
Baht? Dollar? Yen?
Debt
Bonds? Asset-backed?
Convertibles? Hybrids?
Equity
Debt/Equity Swaps?
Private? Public?
Strategic partner?
Domestic? ADRs?
Ownership & control?

13. IBM: What Kind of Debt?
Source: IBM Annual Report 2003

14. Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
COST OF
CAPITAL
Optimal debt ratio?
DEBT
RATIO

15. Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
VALUE OFTHE FIRM
Optimal debt ratio?
DEBT
RATIO

16. Does Capital Structure Matter? Yes!
Assets’ value is the present value of the cash flows from the real business of the firm
Value of the firm
=PV(Cash Flows)
Debt
Equity
Value of the firm
= D + E
Value of Firm
= PV(Cash Flows) + PV(Tax Shield) - Distress Costs

17. Costs and Benefits of Debt
Tax Benefits
Adds discipline to management
Costs of Debt
Bankruptcy Costs
Agency Costs
Loss of Future Flexibility
This summarizes the trade off that we make when we choose between using debt and equity.

18. Tax Benefits of Debt
Tax Benefits: Interest on debt is tax deductible whereas cash flows on equity (like dividends) are not.
Tax benefit each year = t r B
After tax interest rate of debt = (1-t) r
Other things being equal, the higher the marginal tax rate of a corporation, the more debt it will have in its capital structure.
The tax benefit of debt will be lower if the tax code allows some or all of the cash flows to equity to be tax deductible, as well. For instance, in Germany, dividends paid to stockholders are taxed at a lower rate than retained earnings. In these cases, the tax advantage of debt will be lower.
If you do not pay taxes, debt becomes a lot less attractive. Carnival Cruise Lines, which gets most of its business from US tourists pays no taxes because it is domiciled in Liberia. We would expect it to have less debt in its capital structure than a competitor in the US which pays taxes.

19. Debt Adds Discipline to Management
Equity is a cushion; Debt is a sword;
The management of firms which have high cash flows left over each year are more likely to be complacent and inefficient.
This is a quote from Bennett Stewart.
Managers of firms with substantial cash flows and little debt are much more protected from the consequences of their mistakes (especially when stockholders are powerless and boards toothless).
Left to themselves, managers (especially lazy ones) would rather run all-equity financed firms with substantial cash reserves.

20. The expected bankruptcy cost is a function of two variables--
the cost of going bankrupt
direct costs: Legal and other Deadweight Costs
indirect costs: Lost Sales...
durable versus non-durable goods (cars)
quality/safety is important (airlines)
supplementary services (copiers)
the probability of bankruptcy
Studies (see Warner) seem to indicate that the direct costs of bankruptcy are fairly smal.
The indirect cost of going bankrupt comes from the perception that you are in financial trouble, which in turn affects sales and the capacity to raise credit.
As an example, when Apple Computer was perceived to be in financial trouble in early 1997, first-time buyers and businesses stopped buying Apples and software firms stopped coming up with upgrades for products.
Similarly, Kmart found that suppliers started demanding payments in 30 days instead of 60 days, when it got into financial trouble.
The probability of bankruptcy should be a function of the predictability (or variability) of earnings.

21. The Bankruptcy Cost Proposition
Other things being equal, the greater the implicit bankruptcy cost and/or probability of bankruptcy in the operating cash flows of the firm, the less debt the firm can afford to use.
Both the cost of bankruptcy and the probability of bankruptcy go into the expected cost. A firm can have a high expected bankruptcy cost when either or both is high.
If governments step in and provide protection to firms that get into financial trouble, they are reducing the expected cost of bankruptcy. Under that scenario, you would expect firms to borrow more money. (See South Korea)

22. Stockholders incentives are different from bondholder incentives
Agency Cost
Stockholders incentives are different from bondholder incentives
Taking of Risky Projects
Paying large dividends
Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use.
What is good for equity investors might not be good for bondholders and lenders….
A risky project, with substantial upside, may make equity investors happy, but they might cause bondholders, who do not share in the upside, much worse off.
Similarly, paying a large dividend may make stockholders happier but they make lenders less well off.

23. Loss of Future Financing Flexibility
When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt.
Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.
Firms like to preserve flexibility. The value of flexibility should be a function of how uncertain future investment requirements are, and the firm’s capacity to raise fresh capital quickly.
Firms with uncertain future needs and the inability to access markets quickly will tend to value flexibility the most, and borrow the least.

24. Kodak
Source: Bloomberg.com

25. Kodak
Source: morningstar.com

26. Merck
Merck:
P/E 16
Market Cap $112b
Source: morningstar.com

27. Nokia
Nokia:
P/E 34
Market Cap $70b
Source: morningstar.com

28. ABB
ABB:
P/E N/A
Market Cap $5.7b
Source: morningstar.com

29. TDI
Source: moneycentral.msn.com

30. TDI
Twin Disc:
P/E 18.8
Market Cap $39m
Source: morningstar.com

31. See Saw Business Uncertainty Operating Leverage Financial Risk
Financial Leverage
Financial Risk

32. Young and Old Size Maturity Financial Leverage Operating Leverage

33. Capital Structure: Actual vs Optimal
Nestle
Loewen
VALUE OFTHE FIRM
Optimal debt ratio?
DEBT
RATIO

34. Capital Structure: East vs West
Intel
Sammi
VALUE OFTHE FIRM
Optimal debt ratio?
DEBT
RATIO

35. Case Study: Sammi Steel 1989 Acquisition of Atlas
The main advantage from expansion through acquisition was that 500,000 tones of production capacity were purchased for $ mm Vs. building 300,000 tones at $ 500mm. The $ 280mm saved through acquisition was invested in modernization of existing Korean plants so that total production capacity at Sammi Steel rose from 240,000 in 1988 to 750,000 in 1991.
Domestic and Foreign investors supported Sammi’s move to acquire the Atlas group of factories as a good strategic move and the Sammi share price rose from 21,489 Korean won on 12/31/88 to on 12/31/89.

36. How Much Debt?

37. Profits: Zero ~ Risks: High
How Much Debt?
A $19.95 company...an “ISP”
Profits: Zero ~ Risks: High

38. Financing Growth Companies: The Agenda
Where can we get the initial equity financing we need to grow?
Do we want money, management, or more?
When do we want to sell out, and how?
When is the right time for debt for a growth company? What kind?
These are the basic questions that we will try to answer in this part of the discussion.

39. What Kind of Equity? Sources of Equity And Kinds Private investors
Strategic investors
Interventionist investors
Public market
And Kinds
Common stock
Stock with restricted voting rights
Hybrids, including convertibles
This summarizes the trade off that we make when we choose between using debt and equity.

40. Case Study: Photronics

41. 1997: Should Photronics Finance its Growth with Debt?
Benefits of Debt
Tax Benefits
Adds discipline to management
Costs of Debt
Bankruptcy Costs
Agency Costs
Loss of Future Flexibility
This summarizes the trade off that we make when we choose between using debt and equity.

42. Photronics

43. Minimizing the Cost of Capital
Choice Cost
1. Equity Cost of equity
- Retained earnings - depends upon riskiness of the stock
- New stock issues - will be affected by level of interest rates
- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt
- Bank borrowing - depends upon default risk of the firm
- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity and
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

44. Estimating the Cost of Debt
If the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate.
If the firm is rated, use the rating and a typical default spread on bonds with that rating to estimate the cost of debt.
If the firm is not rated,
and it has recently borrowed long term from a bank, use the interest rate on the borrowing or
estimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt
The cost of debt has to be estimated in the same currency as the cost of equity and the cash flows in the valuation.

45. Ratings and Spreads

46. The Cost of Equity Standard approach to estimating cost of equity:
Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)
where,
Rf = Riskfree rate
E(Rm) = Expected Return on the Market Index (Diversified Portfolio)
In practice,
Long term government bond rates are used as risk free rates
Historical risk premiums are used for the risk premium
Betas are estimated by regressing stock returns against market returns

47. Equity Betas and Leverage
The beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio
L = u (1+ ((1-t)D/E)
where
L = Levered or Equity Beta
u = Unlevered Beta
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
While this beta is estimated on the assumption that debt carries no market risk (and has a beta of zero), you can have a modified version:
L = u (1+ ((1-t)D/E) - debt (1-t) D/(D+E)

48. Cost of Capital and Leverage: Method
Equity
Debt
Estimated Beta
With current leverage
From regression
Leverage, EBITDA
And interest cost
Unlevered Beta
With no leverage
Bu=Bl/(1+D/E(1-T))
Interest Coverage
EBITDA/Interest
Levered Beta
With different leverage
Bl=Bu(1+D/E(1-T))
Rating
(other factors too!)
Cost of equity
With different leverage
E(R)=Rf+Bl(Rm-Rf)
Cost of debt
With different leverage
Rate=Rf+Spread+?

49. The Cost of Capital Choice Cost
1. Equity Cost of equity
- Retained earnings - depends upon riskiness of the stock
- New stock issues - will be affected by level of interest rates
- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt
- Bank borrowing - depends upon default risk of the firm
- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity and
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
This provides a summary of the two basic approaches to raising capital - debt and equity. Every other approach is some hybrid of these two.

50. Next, Minimize the Cost of Capital by Changing the Financial Mix
The first step in reducing the cost of capital is to change the mix of debt and equity used to finance the firm.
Debt is always cheaper than equity, partly because it lenders bear less risk and partly because of the tax advantage associated with debt.
But taking on debt increases the risk (and the cost) of both debt (by increasing the probability of bankruptcy) and equity (by making earnings to equity investors more volatile).
The net effect will determine whether the cost of capital will increase or decrease if the firm takes on more or less debt.

51. Siderar: Optimal Debt Ratio
Question: If Siderar’s current debt ratio is 60%, what do you recommend?

52. Siderar: Optimal Debt Ratio

53. Case Study: SAP

54. Case Study: SAP Should SAP take on additional debt? If so, how much?
What is the weighted average cost of capital before and after the additional debt?
What will be the estimated price per share after the company takes on new debt?

55. Case Study: IBM

56. Case Study: IBM

57. A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal
Actual < Optimal
Overlevered
Underlevered
Is the firm under bankruptcy threat?
Is the firm a takeover target?
Yes No
Yes No
Reduce Debt quickly
Increase leverage
Does the firm have good
1. Equity for Debt swap
quickly
Does the firm have good
2. Sell Assets; use cash
projects?
1. Debt/Equity swaps
projects?
to pay off debt
ROE > Cost of Equity
2. Borrow money&
ROE > Cost of Equity
ROC > Cost of Capital
3. Renegotiate with lenders
buy shares.
ROC > Cost of Capital
Yes No
Yes No
Take good projects with
1. Pay off debt with retained
new equity or with retained
earnings.
Take good projects with
earnings.
2. Reduce or eliminate dividends.
debt.
Do your stockholders like
3. Issue new equity and pay off
dividends?
debt.
Yes No
Pay Dividends
Buy back stock

58. First Principles
Invest in projects that yield a return greater than the minimum acceptable hurdle rate.
The hurdle rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.
Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.
If there are not enough investments that earn the hurdle rate, return the cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon the stockholders’ characteristics.
This completes our discussion of the second leg of corporate finance.

59. Links
Useful Links Company information: biz.yahoo.com/ifc Industry ratios: Debt ratings and spreads: bondsonline.com

64. Contact NYU Stern School of Business 44 West 4th Street
New York, NY 10012, USA