THE CAPITAL STRUCTURE DECISION The debt - equity trade off

BASIC PRINCIPLES INVEST IF YIELD > HURDLE RATE CHOOSE FINANCING MIX THAT MINIMIZES THE HURDLE RATE IF MARGINAL INVESTMENT YIELD < HURDLE RATE, RETURN CASH TO SHAREHOLDERS

AGENDA WHAT IS DEBT? HOW TO DECIDE THE OPTIMAL MIX OF DEBT AND EQUITY? HOW ALTERING THE MIX AFFECTS COMPANY VALUE? WHAT IS RIGHT KIND OF DEBT FOR THE FIRM?

WHAT IS DEBT? COMMITMENT TO FIXED FUTURE PAYMENTS FIXED PAYMENTS ARE TAX DEDUCTIBLE FAILURE TO MAKE PAYMENTS - DEFAULT OR LOSS OF CONTROL

FINANCIAL LEVERAGE TWO DEBT RATIOS INCLUDE : DEBT/CAPITAL OR DEBT/EQUITY DEBT CAN BE EITHER ALL DEBT OR LONG TERM DEBT BOOK VALUE OR MARKET VALUE

M & M THEOREM (1) NO TRANSACTIONS COSTS NO TAXES AND BANKRUPTCY COSTS TOTAL AGREEMENT PERFECTLY COMPETITVE MARKETS EQUAL BORROWING AND LENDING RATES SET COMPANY ASSET STRUCTURE

M & M WORLD (2) CAPITAL STRUCTURE IS IRRELEVANT VALUE OF FIRM IS INDEPENDENT OF ITS DEBT RATIO –IE. FIRM’S VALUE DETERMINED BY PROJECT INVESTMENT CASH FLOWS

BENEFITS/COSTS OF DEBT BENEFITS TAX BENEFITS ADDS DISCIPLINE TO MANAGEMENT COSTS BANKRUPTCY COSTS AGENCY COSTS LOSS OF FUTURE FLEXIBILITY

TAX BENEFITS OF DEBT INTEREST (NOT DIVIDENDS) ARE TAX DEDUCTIBLE BENEFIT = TAX RATE (X) INTEREST RATE (X) DOLLAR AMOUNT OF DEBT Other thing equal, greater tax rate the more debt the firm will have in its capital structure

EXAMPLE REAL ESTATE CORP - TAXED REAL ESTATE INV. TRUST - NO TAX BUT MUST PAY OUT 95% OF EARNINGS AS DIVIDENDS WHICH ONE OF THE TWO FIRMS WOULD HAVE HIGHER DEBT RATIO?

DEBT ADDS DISCIPLINE EQUITY IS A CUSHION; DEBT A SWORD MANAGEMENT OF FIRMS WITH HIGH FREE CASH FLOW MAY BECOME COMPLACENT AND INEFFICIENT

WHO BENEFITS MOST FROM DEBT? CONSERVATIVELY FINANCED PRIVATE FIRM CONSERVATIVELY FINANCED PUBLCLY TRADED FIRM WITH DIVERSE STOCK HOLDING SAME AS 2# BUT WITH PRIMARILY INSTITUTIONAL INVESTORS

BANKRUPTCY COST COST OF GOING BANKRUPT –DIRECT - LEGAL AND OTHER DEADWEIGHT COSTS –INDIRECT - LOST SALES PROBABILITY OF BANKRUPTCY

BANKRUPTCY COST OTHER THINGS EQUAL, GREATER THE IMPLICIT BANKRUPTCY COST AND/OR PROBABILITY OF BANKRUPTCY, THE LESS DEBT THE FIRM CAN AFFORD TO USE

RANK ACCORDING TO BANKRUPTCY COST GROCERY STORE AIRPLANE MANUFACTURER HIGH TECHNOLOGY COMPANY

AGENCY COSTS STOCKHOLDERS HAVE DIFFERENT INCENTIVES THAN BONDHOLDER EXAMPLE 1 - TAKING RISKY PROJECTS EXAMPLE 2 -PAYING LARGE DIVIDENDS

AGENCY ISSUES from text FREE CASH FLOW EX-POST EXPROPRIATION UNDER-INVESTMENT NO-LIQUIDATION

AGENCY COSTS OTHER THINGS EQUAL, GREATER THE AGENCY PROBLEMS OF LENDING TO A FIRM, THE LESS DEBT THE FIRM CAN AFFORD TO USE

LOSS OF FINANCING FLEXIBILITY IF BORROWS UP TO DEBT CAPACITY, LIMITED FLEXIBILITY IN FINANCING FUTURE PROJECTS OTHER THINGS EQUAL, MORE UNCERTAIN THE FUTURE FINANCING NEEDS, THE LESS DEBT THE FIRM WILL USE