Capital Structure: How to finance a firm

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Capital Structure How to finance a firm

• Prof. P.V. Viswanath
• EDHEC
• June 2008

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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

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Internal vs External Finance

• For an ongoing firm, financing can be obtained by
  simply retaining the earnings generated by the
  firm, if they are positive.
• Alternatively, if firm earnings are not
  sufficient, it might be necessary to go outside
  the firm.
• A firm may also choose to pay dividends and still
  raise funds outside the firm, if its stockholders
  want to have a predictable stream of dividends.

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The Choices in External 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.

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Kinds of Debt Financing

• Debt financing could be short-term or long-term.
• Short-term debt includes a promise to return the
  borrowing to the lenders within a short period of
  time, usually one year or less.
• Short-term debt could be bank debt or
• It could be commercial paper, which is debt
  issued and sold in the capital markets
  individuals and financial intermediaries buy
  corporate commercial paper.
• Long-term debt has a maturity usually longer than
  one year.

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Long-term debt

• Long term debt is usually in the form of debt
  securities sold by the firm to individuals and
  financial intermediaries.
• Debt can be secured by collateral. In this case,
  the holder of the debt gets first priority on
  those assets in case the firm defaults on its
  promised payments.
• Long-term leases are a form of secured debt. A
  long-term lease involves the long-term rental of
  an asset. This is more or less equivalent to
  buying an asset and borrowing to finance it with
  the asset itself as collateral.
• The difference is that in the case of a long-term
  lease, the lessor bears the risk that the
  residual value of the asset might drop.

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Debt versus Equity
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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 bondholders often
  impose conditions called covenants with equity
  there are no covenants to worry about
• Equity allows for better alignment of
  stakeholder/ management goals

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A Life Cycle View of Financing Choices
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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?

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Measuring a firms 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, its convenient to use a Long-Term
  Debt/Capital ratio many of the agency problems
  with LT debt dont 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.

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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?
• Lets see why there might be one.

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Capital Structure Irrelevance

• If there are no leakages (i.e. payouts to parties
  other than the security holders of the firm that
  are a function of capital structure), then
• The value of a company derives from the
  operations of the company. 
• Changes in capital structure only affect the way
  in which the distribution of the cash flows
  between stockholders and bondholders is achieved.
  
• Hence the value of the firm should be independent
  of its capital structure.
• However, in practice there are many such leakages
  and hence not all capital structures are
  equivalent.

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Costs and Benefits of Debt

• These leakages sometimes work to increase the
  optimality of debt and sometimes to decrease the
  optimality of debt (increase the optimality of
  equity)
• Benefits of Debt
• Tax Benefits
• Adds discipline to management
• Costs of Debt
• Bankruptcy Costs
• Agency Costs
• Loss of Future Flexibility

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Tax Benefits of Debt

• When you borrow money, you are allowed to deduct
  interest expenses from your income to arrive at
  taxable income. This reduces your taxes. When you
  use equity, you are not allowed to deduct
  payments to equity (such as dividends) to arrive
  at taxable income.
• The dollar tax benefit from the interest payment
  in any year is a function of your tax rate and
  the interest payment
• Tax benefit each year Tax Rate Interest
  Payment

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Tax Benefit Proposition

• Proposition 1 Other things being equal, the
  higher the marginal tax rate of a business, the
  more debt it will have in its capital structure.

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The Effects of Taxes

• You are comparing the debt ratios of real estate
  corporations, which pay the corporate tax rate,
  and real estate investment trusts, which are not
  taxed, but are required to pay 90 of their
  earnings as dividends to their stockholders.
  Which of these two groups would you expect to
  have the higher debt ratios?
• ? The real estate corporations
• ? The real estate investment trusts
• ? Cannot tell, without more information

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Implications of The Tax Benefit of Debt

• The debt ratios of firms with higher tax rates
  should be higher than the debt ratios of
  comparable firms with lower tax rates.
• Firms that have substantial non-debt tax shields,
  such as depreciation, should be less likely to
  use debt than firms that do not have these tax
  shields.
• If tax rates increase over time, we would expect
  debt ratios to go up over time as well,
  reflecting the higher tax benefits of debt.
• Although it is always difficult to compare debt
  ratios across countries, we would expect debt
  ratios in countries where debt has a much larger
  tax benefit to be higher than debt ratios in
  countries whose debt has a lower tax benefit.

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Debt adds discipline to management

• If you are managers of a firm with no debt, and
  you generate high income and cash flows each
  year, you tend to become complacent. The
  complacency can lead to inefficiency and
  investing in poor projects. There is little or no
  cost borne by the managers
• Forcing such a firm to borrow money can be an
  antidote to the complacency. The managers now
  have to ensure that the investments they make
  will earn at least enough return to cover the
  interest expenses. The cost of not doing so is
  bankruptcy and the loss of such a job.

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Debt and Discipline

• Assume that you buy into this argument that debt
  adds discipline to management. Which of the
  following types of companies will most benefit
  from debt adding this discipline?
• ? Conservatively financed (very little debt),
  privately owned businesses
• ? Conservatively financed, publicly traded
  companies, with stocks held by millions of
  investors, none of whom hold a large percent of
  the stock.
• ? Conservatively financed, publicly traded
  companies, with an activist and primarily
  institutional holding.

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Empirical Evidence on the Discipline of Debt

• Firms that are acquired in hostile takeovers are
  generally characterized by poor performance in
  both accounting profitability and stock returns.
• There is evidence that increases in leverage are
  followed by improvements in operating efficiency,
  as measured by operating margins and returns on
  capital.
• Palepu (1990) presents evidence of modest
  improvements in operating efficiency at firms
  involved in leveraged buyouts.
• Kaplan(1989) and Smith (1990) also find that
  firms earn higher returns on capital following
  leveraged buyouts.
• Denis and Denis (1993) study leveraged
  recapitalizations and report a median increase in
  the return on assets of 21.5.

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Debt and Bankruptcy Costs

• A firm that uses debt could go bankrupt if it
  cant make its promised payments.
• The expected bankruptcy cost is a function of two
  variables-
• the cost of going bankrupt
• direct costs Legal and other Deadweight Costs
• indirect costs Costs arising because people
  perceive you to be in financial trouble and
  acting contrary to your interests
• the probability of bankruptcy, which will depend
  upon how uncertain you are about future cash
  flows
• As you borrow more, you increase the probability
  of bankruptcy and hence the expected bankruptcy
  cost.

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Indirect Bankruptcy Costs

• When customers perceive that a firm is likely to
  go bankrupt, they are less likely to buy from
  that firm if the continued enjoyment of their
  purchases depends upon the continued existence of
  the firm.
• When suppliers perceive that a firm is likely to
  go bankrupt, they are less likely to sell to that
  firm on credit.

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Indirect Bankruptcy Costs should be highest for.

• Firms that sell durable products with long lives
  that require replacement parts and service
• Firms that provide goods or services for which
  quality is an important attribute but where
  quality difficult to determine in advance if
  the firm goes bankrupt by the time that the
  quality is determined to be low, customers cannot
  go to the firm for compensation.
• Firms producing products whose value to customers
  depends on the services and complementary
  products supplied by independent companies
• Firms that sell products requiring continuous
  service and support from the manufacturer

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The Bankruptcy Cost Proposition

• Proposition 2 Other things being equal, the
  greater the indirect bankruptcy cost and/or
  probability of bankruptcy in the operating
  cashflows of the firm, the less debt the firm can
  afford to use.

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Debt Bankruptcy Cost

• Rank the following companies on the magnitude of
  bankruptcy costs from most to least, taking into
  account both explicit and implicit costs
• A Grocery Store
• An Airplane Manufacturer
• High Technology company

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Implications of Bankruptcy Cost Proposition

• Firms operating in businesses with volatile
  earnings and cash flows should use debt less than
  otherwise similar firms with stable cash flows.
• If firms can structure their debt in such a way
  that the cash flows on the debt increase and
  decrease with their operating cash flows, they
  can afford to borrow more.
• If an external entity, such as the government or
  an agency of the government, provides protection
  against bankruptcy through either insurance or
  bailouts for troubled firms, firms will tend to
  borrow more.
• Firms with assets that can be easily divided and
  sold should borrow more than firms with assets
  that are less liquid.

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Agency Cost

• An agency cost arises whenever you hire someone
  else to do something for you. It arises because
  your interests(as the principal) may deviate from
  those of the person you hired (as the agent).
• When you lend money to a business, you are
  allowing the stockholders to use that money in
  the course of running that business. Stockholders
  interests are different from your interests,
  because
• You (as lender) are interested in getting your
  money back
• Stockholders are interested in maximizing your
  wealth
• In some cases, the clash of interests can lead to
  stockholders
• Investing in riskier projects than you would want
  them to
• Paying themselves large dividends when you would
  rather have them keep the cash in the business.

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Agency Cost Proposition

• Proposition Other things being equal, the
  greater the agency problems associated with
  lending to a firm, the less debt the firm can
  afford to use.

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Debt and Agency Costs

• Assume that you are a bank. Which of the
  following businesses would you perceive the
  greatest agency costs?
• A Large Pharmaceutical company
• A Large Regulated Electric Utility
• Why?

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How agency costs show up...

• If bondholders believe there is a significant
  chance that stockholder actions might make them
  worse off, they can build this expectation into
  bond prices by demanding much higher rates on
  debt.
• If bondholders can protect themselves against
  such actions by writing in restrictive covenants,
  two costs follow
• the direct cost of monitoring the covenants,
  which increases as the covenants become more
  detailed and restrictive.
• the indirect cost of lost investments, since the
  firm is not able to take certain projects, use
  certain types of financing, or change its payout
  this cost will also increase as the covenants
  becomes more restrictive.

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Implications of Agency Costs..

• The agency cost arising from risk shifting is
  likely to be greatest in firms whose investments
  cannot be easily observed and monitored. These
  firms should borrow less than firms whose assets
  can be easily observed and monitored.
• The agency cost associated with monitoring
  actions and second-guessing investment decisions
  is likely to be largest for firms whose projects
  are long term, follow unpredictable paths, and
  may take years to come to fruition. These firms
  should also borrow less.

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Loss of future financing flexibility

• When a firm borrows up to its capacity, it loses
  the flexibility of financing future projects with
  debt.
• Proposition 4 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.

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Debt Summarizing the Trade Off
Advantages of Borrowing
Disadvantages of Borrowing
1. Tax Benefit


1. Bankruptcy Cost
Higher tax rates --gt Higher tax benefit
Higher business risk --gt Higher Cost
2. Added Discipline
2. Agency Cost
Greater the separation between managers
Greater the separation between stock-
and stockholders --gt Greater the benefit
holders lenders --gt Higher Cost
3. Loss of Future Financing Flexibility
Greater the uncertainty about future

financing needs --gt Higher Cost