The Debt/Equity Tradeoff: Tax Benefits, Disciplinary Mechanism, Bankruptcy & Agency Costs, Financial Flexibility

1. The Debt/equity tradeoff Aswath Damodaran

2. The trade off on debt versus equity

3. The trade off at “your” firm • Considering, for your firm, • The potential tax benefits of borrowing • The benefits of using debt as a disciplinary mechanism • The potential for expected bankruptcy costs • The potential for agency costs • The need for financial flexibility • Would you expect your firm to have a high debt ratio or a low debt ratio? • Does the firm’s current debt ratio meet your expectations?

4. Let’s start with potential tax benefits • Marginal tax rate: Start with the marginal tax rate of the country in which the company is domiciled. If, as is common, the company gets the largest share of its income from the domestic market, the higher the marginal tax rate, the more debt you should have. • Effective tax rate: While it is true that debt saves you taxes at the margin, it is also true that the lower the effective tax rate, the more likely it is that the company has already found other ways to shelter itself from taxes and needs debt less.

5. Marginal tax rates In 2012 Black #: Total ERP Red #: Country risk premium AVG: GDP weighted average

6. Effective tax rates across sectors: US in 2013

7. Added Discipline • Past Project Choice: Companies that have generated poor returns on their investments in the past, measured using return on capital and/or return on equity are better candidates. • Past stock price performance: Companies whose stocks have under performed the market (Jensen’s alpha) are better candidates. • Insider holdings: Companies where the top managers hold less stock are better candidates. • Activist presence: If an activist or activists are among the top holders, there is less need for debt.

8. Expected Bankruptcy CostI. The Probability of Bankruptcy • Quantitative measures • Level of operating earnings: Companies with higher cashflow available to service debt should be able to borrow more. • Variance in earnings: Companies that operate in businesses where earnings are more volatile face a higher probability of bankruptcy. • Dependence on one or a few customers: A firm that is dependent on one or a few customers is more exposed. • Qualitative measures • Possibility of “catastrophic” risk: If there is a possibility of a catastrophic risk, it is best to hold back on debt. • Competition: All else held constant, the more competitive the business, the more risk you face in earnings. • Product type: Products that change quickly or have short life cycles expose you to more bankruptcy risk.

9. II. The Cost of Bankruptcy • Direct costs: If a company’s assets are liquid and easily marketable, it should face less direct cost in liquidation than if its assets are illiquid, unique or have few buyers. • Indirect costs: The more damage that can be done to both revenues and operations by the perception that you are in trouble, the greater the indirect bankruptcy cost.

10. Agency CostsThink like a lender! • Type of assets: The more easily you can observe the assets that your lending is used to acquire, the more comfortable you feel lending money to a firm. Companies with more physical, fixed assets should have higher debt ratios than companies with intangible assets. • Monitoring: The more easily you can monitor how a firm invests and spends its money, the more comfortable you feel about lending money. • History: The more “good” history a firm has in borrowing money and returning the money, the more comfortable you feel lending your money.

11. Loss of flexibilityFuture financing needs • Amount of future financing needs: A firm that has less future financing needs should be able to borrow more money than one that has more. • Predictability of future financing needs: A firm that has more volatility in its financing needs will borrow less than one that has a predictable financing need.