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Finding the Right Financing Mix: The Capital Structure Decision

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1 Finding the Right Financing Mix: The Capital Structure Decision
P.V. Viswanath Based on Damodaran’s Corporate Finance

2 Objective: Maximize the Value of the Firm
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. Objective: Maximize the Value of the Firm The emphasis in this section is on analyzing a firm’s financing mix - debt versus equity. Note contradiction re statement here on hurdle rate being dependent on financing mix, whereas in the section on risk analysis, we said that discount rates depended on characteristics of cashflow generated by the assets. The two are the same where Modigliani-Miller holds. Else, we know that asset cashflows depend on agency costs generated by the financing structure. P.V. Viswanath

3 The Choices in Financing
There are only two ways in which a business can raise money. The first is debt. 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. The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments. While there are several different financing instruments available to a firm, they can all be categorized either as debt or equity. Furthermore, this is a choice that both private and public firms have to make. P.V. Viswanath

4 Debt versus Equity P.V. Viswanath
The contrast between debt and equity lie in the different claim each has on the cash flows of a business and the degree of control each exercises over the business. The best way to determine whether a financing is debt or equity is to ask three questions: Is the cash flow claim created by this financing a fixed commitment or a residual claim? Is this commitment tax deductible? If you fail to make the commitment, do you lose control of the business? If the answer is yes to all three questions, the financing is debt. If it is no to even one, it is either equity or a hybrid financing. P.V. Viswanath

5 Debt versus Equity One can also look at debt and equity from the viewpoint of management Debt provides leverage and hence the opportunity for higher returns Debt forces discipline on management Equity allows more flexibility Equity allows more control – no covenants to worry about Equity imposes fewer agency costs – better alignment of stakeholder/management goals P.V. Viswanath

6 The Choices Equity can take different forms:
For very small businesses: it can be owners investing their savings For slightly larger businesses: it can be venture capital For publicly traded firms: it is common stock Debt can also take different forms For private businesses: it is usually bank loans For publicly traded firms: it can take the form of bonds Equity and debt does not always mean stocks and bonds. P.V. Viswanath

7 A Life Cycle View of Financing Choices
The type of financing used by a firm is likely to reflect where in the life cycle the firm is currently. Small firms, early in the life cycle, will tend to use venture capital and bank debt to raise funds. Larger firms, which are more mature, will tend to issue bonds. Firms also make transitions from one stage to another - by going public first and then making seasoned equity or debt offerings. P.V. Viswanath

8 The Financing Mix Question
In deciding to raise financing for a business, is there an optimal mix of debt and equity? If yes, what is the trade off that lets us determine this optimal mix? If not, why not? This is the basic question that we will cover in the first part of the analysis. P.V. Viswanath

9 Measuring a firm’s financing mix
The simplest measure of how much debt and equity a firm is using currently is to look at the proportion of debt in the total financing. This ratio is called the debt to capital ratio: Debt to Capital Ratio = Debt / (Debt + Equity) This is also called the Debt to Assets Ratio Debt includes all interest bearing liabilities, short term as well as long term. Often, it’s convenient to use a Long-Term Debt/Capital ratio – many of the agency problems with LT debt don’t exist with short-term debt because of the short maturity. Equity can be defined either in accounting terms (as book value of equity) or in market value terms (based upon the current price). The resulting debt ratios can be very different. The difference between book value and market value debt ratios can give rise to problems. For instance, most published debt ratios are book value debt ratios and many analysts talk about book debt ratios when talking about financial leverage. The higher the expected growth rate in a firm, the greater will be the difference between book and market value. P.V. Viswanath

10 Industries and Capital Structures
Capital Structures seem to vary by industries: Tech-based industries have little debt Utilities have a lot of debt Is there a pattern? P.V. Viswanath

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