THE DEBTEQUITY TRADEOFF Aswath Damodaran The trade off

THE DEBT/EQUITY TRADEOFF Aswath Damodaran

The trade off on debt versus equity 2

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? 3

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. 4

Marginal tax rates In 2012 Bahamas Bermuda Bonaire Cayman Islands Georgia Guernsey Isle of Man Jersey Canada USA N. America Argentina Bolivia Brazil Chile Colombia Costa Rica Ecuador El Salvador Guatemala Honduras Mexico Panama Paraguay Peru Uruguay Venezuela Latin America 5 0. 00% 0. 00% 26% 40% 33% 35% 25% 34% 18. 5% 33% 30% 23% 30% 31% 35% 30% 25% 10% 30% 25% 34% 28. 3% Belgium Germany Portugal Italy Luxembourg Austria Denmark France 33. 99% 29. 48% 25% 31. 4% 28. 8% 25% 33. 3% Finland 24. 5% Greece Iceland 20% Ireland 12. 5% Netherlands Norway Slovenia Spain Sweden Switzerland Turkey UK W. Europe Angola Botswana Egypt Kenya Mauritius Namibia Nigeria South Africa Tunisia Zambia Africa 25% 28% 18% 30% 26. 3% 21. 2% 20% 24% 22. 6% 35% 22% 25% 30% 15% 34% 30% 34. 6% 30% 35% 29% Albania Armenia Belarus Bosnia & Herzegovina Bulgaria Croatia Czech Republic Estonia Georgia Hungary Kazakhstan Latvia Lithuania Montenegro Poland Romania Russia Slovakia Slovenia Ukraine E. Europe & Russia Bahrain Israel Jordan Kuwait Libya Oman Qatar Saudi Arabia Middle East 10% 20% 18% 10% 20% 19% 21% 0% 19% 20% 15% 9% 16% 20% 19% 18% 21% Bangladesh Cambodia China Fiji Islands Hong Kong India Indonesia Japan Korea Malaysia Pakistan Papua New Guinea Philippines Singapore Sri Lanka Taiwan Thailand Vietnam Asia 27. 5% 20% 25% 28% 16. 5% 32. 5% 25% 38% 24. 2% 25% 30% 30% 17% 28% 17% 23% 25% 22. 9% 20. 5% 0% 25% 14% 15% 20% 12% 10% 20% 14% Australia New Zealand Australia & NZ 30% 28% 29% Black #: Total ERP Red #: Country risk premium AVG: GDP weighted average

Effective tax rates across sectors: US in 2013 Industry name Advertising Aerospace/Defense Air Transport Apparel Auto Parts Automotive Bank (Midwest) Beverage Biotechnology Building Materials Cable TV Chemical (Basic) Chemical (Diversified) Chemical (Specialty) Coal Computer Software Computers/Peripherals Diversified Co. Drug E-Commerce Educational Services Electric Util. (Central) Electric Utility (East) Electric Utility (West) Tax rate 32. 82% 30. 74% 31. 82% 33. 28% 30. 29% 17. 11% 24. 92% 24. 78% 32. 52% 20. 48% 26. 15% 37. 23% 25. 68% 26. 32% 26. 64% 17. 27% 25. 35% 23. 26% 28. 09% 18. 67% 27. 19% 32. 70% 32. 00% 33. 57% 30. 05% Industry name Electrical Equipment Electronics Engineering & Const Entertainment Tech Environmental Financial Svcs. (Div. ) Food Processing Foreign Electronics Funeral Services Furn/Home Furnishings Healthcare Information Heavy Truck & Equip Homebuilding Hotel/Gaming Household Products Human Resources Industrial Services Information Services Insurance (Life) Insurance (Prop/Cas. ) Internet Investment Companies IT Services Machinery Tax rate 25. 00% 22. 26% 38. 23% 27. 43% 20. 67% 26. 91% 31. 17% 32. 51% 37. 69% 32. 15% 25. 84% 38. 51% 23. 97% 35. 07% 31. 30% 30. 67% 37. 10% 37. 37% 27. 31% 28. 84% 20. 89% 29. 30% 20. 06% 23. 93% 28. 47% Industry name Machinery Maritime Med Supp Invasive Med Supp Non-Invasive Medical Services Metal Fabricating Metals & Mining (Div. ) Natural Gas Utility Newspaper Office Equip/Supplies Oil/Gas Distribution Oilfield Svcs/Equip. Packaging & Container Paper/Forest Products Petroleum (Integrated) Petroleum (Producing) Pharmacy Services Pipeline MLPs Power Precious Metals Precision Instrument Property Management Public/Private Equity Publishing Tax rate 28. 47% 17. 65% 29. 81% 27. 13% 34. 76% 34. 47% 32. 14% 28. 85% 36. 69% 27. 30% 31. 59% 25. 78% 25. 81% 27. 51% 17. 71% 35. 29% 24. 60% 31. 87% 11. 79% 33. 64% 30. 29% 24. 56% 34. 40% 23. 29% 39. 57% Industry name R. E. I. T. Railroad Recreation Reinsurance Restaurant Retail (Hardlines) Retail (Softlines) Retail Automotive Retail Building Supply Retail Store Retail/Wholesale Food Securities Brokerage Semiconductor Equip Shoe Steel Telecom. Equipment Telecom. Services Telecom. Utility Thrift Tobacco Toiletries/Cosmetics Trucking Water Utility Wireless Networking Total Market Tax rate 6. 75% 31. 78% 30. 40% 14. 88% 27. 82% 32. 79% 34. 66% 34. 57% 39. 97% 35. 25% 34. 37% 44. 89% 21. 72% 15. 91% 31. 23% 33. 30% 28. 32% 30. 64% 38. 10% 27. 52% 37. 16% 31. 90% 36. 73% 34. 63% 28. 11% 28. 37%

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. 7

Expected Bankruptcy Cost I. 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. 8

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. 9

Agency Costs Think like a lender! 1. 2. 3. 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. 10

Loss of flexibility Future 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. 11