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Understanding Capital Structure Decisions: Debt vs. Equity Trade-Off

This text explores the fundamental principles behind capital structure decisions, emphasizing the critical debt-equity trade-off. It discusses how to invest when yields exceed hurdle rates and the importance of choosing a financing mix that minimizes these rates. The document also covers the nature of debt, its implications on the company value, bankruptcy costs, and agency issues. Key considerations include tax benefits of debt, the relationship between debt ratios and firm value, and strategies for managing financial leverage effectively.

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Understanding Capital Structure Decisions: Debt vs. Equity Trade-Off

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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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