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THE CAPITAL STRUCTURE DECISION

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?

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THE CAPITAL STRUCTURE DECISION

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  1. THE CAPITAL STRUCTURE DECISION The debt - equity trade off

  2. 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

  3. 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?

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

  5. 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

  6. 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

  7. 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

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

  9. 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

  10. 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?

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

  12. 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

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

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

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

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

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

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

  19. 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

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