Brief Overview of Debt and Equity Aswath Damodaran

Brief Overview of Debt and Equity Aswath Damodaran / Expanded and Edited by Del Hawley 1

The Only Two Choices for Financing Debt (Leverage) • 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. Equity • With equity, you do get whatever cash flows are left over after you have made debt payments. Aswath Damodaran / Expanded and Edited by Del Hawley 2

Debt versus Equity Debt Equity Fixed Claim Residual Claim High Priority on Cash Flows Lowest Priority on Cash Flows Interest is Tax Deductible No Tax Break on Dividends Infinite Life Fixed Maturity Aswath Damodaran / Expanded and Edited by Del Hawley 3

When Is It Debt? Ask 3 Questions: 1. Is the cashflow claim created by this financing a fixed commitment or a residual claim? 2. Is the commitment tax-deductible? 3. If you fail to uphold the commitment, do you lose control of the business? If all three answers are “Yes”, it’s debt. Otherwise, it’s equity or a hybrid. Aswath Damodaran / Expanded and Edited by Del Hawley 4

Cost of Debt is always the least costly form of financing. WHY? Aswath Damodaran / Expanded and Edited by Del Hawley 5

Cost of Debt vs. Equity E(R) Equity Rf Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be lower. Debt β Aswath Damodaran / Expanded and Edited by Del Hawley 6

Debt versus Equity Factor Cost Debt Lowest High: Bankruptcy Risk to the Firm and volatility of cashflows Equity Highest Low Impact on Flexibility High: Major restrictions on decision making Low: Few restrictions on decision making Impact on Control Low, unless firm is in bankruptcy Potentially High: Many owners Aswath Damodaran / Expanded and Edited by Del Hawley 7

The Choices Equity can take different forms: • Small business owners investing their savings • Venture capital for startups • Common stock for corporations Debt can also take different forms • For private businesses, it is usually bank loans • For publicly traded firms, it is more likely to be debentures (bonds) for long-term debt and commercial paper for short-term debt Aswath Damodaran / Expanded and Edited by Del Hawley 8

Compare Advantages and Disadvantages of Debt Advantages of Debt • Interest is tax-subsidized Low cost • Increases upside variability of cashflows to equity • Adds discipline to management Disadvantages of Debt • Possibility of bankruptcy/financial distress • Increases downside variability of cashflows to equity • Agency costs are incurred • Loss of future flexibility Aswath Damodaran / Expanded and Edited by Del Hawley 9

What Does Leverage Mean? Depending on where the fulcrum is placed, a small force can be amplified into a much larger force. Aswath Damodaran / Expanded and Edited by Del Hawley 10

What Does Leverage Mean? In financial leverage, the fulcrum is the fixed cost of the debt financing. The small force is variability of operating income. The large force is the variability of cashflows to shareholders (EPS) Aswath Damodaran / Expanded and Edited by Del Hawley 11

What Does Leverage Mean? The larger the fixed interest payments… The more a small change in operating profit… Will be amplified into a larger change in EPS Aswath Damodaran / Expanded and Edited by Del Hawley 12

What managers consider important in deciding on how much debt to carry. . . A survey of Chief Financial Officers of large U. S. companies provided the following ranking (from most important to least important) for the factors that they considered important in the financing decisions Factor Ranking (0 -5) 1. Maintain financial flexibility 4. 55 2. Ensure long-term survival 4. 55 3. Maintain Predictable Source of Funds 4. 05 4. Maximize Stock Price 3. 99 5. Maintain financial independence 3. 88 6. Maintain high debt rating 3. 56 7. Maintain comparability with peer group 2. 47 Aswath Damodaran / Expanded and Edited by Del Hawley 13

Why does the Capital Structure Mix matter? Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital. If the cash flows to the firm are held constant and the cost of capital is minimized, the value of the firm will be maximized. So, if capital structure changes do not affect the cost of capital, then capital structure is irrelevant since it will not affect firm value. Aswath Damodaran / Expanded and Edited by Del Hawley 14

The Most Realistic View of Capital Structure… Aswath Damodaran / Expanded and Edited by Del Hawley 15

The Most Realistic View of Capital Structure… The tax advantage of debt would be progressively offset by the rising potential for bankruptcy and the resulting financial distress costs, and also by the rising agency costs. The result would be that the WACC would fall as debt went from zero to some larger amount, but would eventually reach a minimum and then start to climb. Thus, there would be an optimal capital structure where the WACC is minimized. This would be less that 100% debt. Aswath Damodaran / Expanded and Edited by Del Hawley 16