Aswath Damodaran 1
CORPORATE FINANCE
LECTURE NOTE PACKET 2
CAPITAL STRUCTURE, DIVIDEND
POLICY AND VALUATION
Aswath Damodaran Spring 2024
Aswath Damodaran 2
CAPITAL STRUCTURE: THE
CHOICES AND THE TRADE OFF
“Neither a borrower nor a lender be”
Someone who obviously hated this part of corporate finance
First principles
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The Choices in Financing
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Global Patterns in Financing…
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And a much greater dependence on bank loans
outside the US…
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¨ In broad terms, borrowing can come from banks/lenders or
from issuing corporate bonds.
¨ In the United States, companies have had more access to
corporate bonds than companies in other markets.
¤ That access which initially started for larger companies expanded to
cover smaller ones.
¤ In the 1980s, Mike Milken opened up the bond market to issuers who
had below investment grade ratings with the junk bond market.
¨ In the last two or three decades, bond markets have opened
up for companies in the rest of the world as well.
¨ As a borrower, with a choice of issuing corporate bonds or
raising bank loans, why might you pick one over the other?
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Assessing the existing financing choices: Disney,
Vale, Tata Motors, Baidu & Bookscape
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The Transitional Phases..
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¨ The transitions that we see at firms – from fully owned
private businesses to venture capital, from private to public
and subsequent seasoned offerings are all motivated
primarily by the need for capital.
¨ In each transition, though, there are costs incurred by the
existing owners:
¤ When venture capitalists enter the firm, they will demand their fair
share and more of the ownership of the firm to provide equity.
¤ When a firm decides to go public, it has to trade off the greater access
to capital markets against the increased disclosure requirements (that
emanate from being publicly lists), loss of control and the transactions
costs of going public.
¤ When making seasoned offerings, firms have to consider issuance
costs while managing their relations with equity research analysts and
rat
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Measuring a firm’s financing mix …
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¨ The simplest measure of how much debt and equity a firm is
using currently is to look at the proportion of debt in the total
financing. This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
¨ Debt includes all interest bearing liabilities, short term as well
as long term. It should also include other commitments that
meet the criteria for debt: contractually pre-set payments
that have to be made, no matter what the firm’s financial
standing.
¨ Equity can be defined either in accounting terms (as book
value of equity) or in market value terms (based upon the
current price). The resulting debt ratios can be very different.
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The Financing Mix Question
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¨ In deciding to raise financing for a business, is there
an optimal mix of debt and equity?
¤ If yes, what is the trade off that lets us determine this
optimal mix?
n What are the benefits of using debt instead of equity?
n What are the costs of using debt instead of equity?
¤ If not, why not?
¨ To answer this question, you have to decide what
you are optimizing first, and in corporate finance,
that is firm value.
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The Illusory Benefits of Debt
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Costs and Benefits of Debt
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¨ Benefits of Debt
¤ Tax Benefits: The tax code is tilted in favor of debt, with interest
payments being tax deductible in most parts of the world, while
cash flows to equity are not.
¤ Adds discipline to management: When managers are sloppy in
their project choices, borrowing money may make them less so.
¨ Costs of Debt
¤ Bankruptcy Costs: Borrowing money will increase your expected
probability and cost of bankruptcy.
¤ Agency Costs: What’s good for stockholders is not always what’s
good for lenders and that creates friction and costs.
¤ Loss of Future Flexibility: Using up debt capacity today will mean
that you will not be able to draw on it in the future.
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Tax Benefits of Debt
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¨ When you borrow money, you are allowed to deduct interest
expenses from your income to arrive at taxable income. This
reduces your taxes. When you use equity, you are not
allowed to deduct payments to equity (such as dividends) to
arrive at taxable income.
¨ The dollar tax benefit from the interest payment in any year is
a function of your tax rate and the interest payment:
n Tax benefit each year = Tax Rate * Interest Payment
n The caveat is that you need to have the income to cover interest
payments to get this tax benefit.
¨ Proposition 1: Other things being equal, the higher the
marginal tax rate of a business, the more debt it will have in
its capital structure.
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The Effects of Taxes
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¨ You are comparing the debt ratios of real estate
corporations, which pay the corporate tax rate, and
real estate investment trusts, which are not taxed,
but are required to pay 95% of their earnings as
dividends to their stockholders. Which of these two
groups would you expect to have the higher debt
ratios?
a. The real estate corporations
b. The real estate investment trusts
c. Cannot tell, without more information
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Tax Law and Debt
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¨ At the end of 2017, the United States had one of the
highest marginal corporate tax rates in the world (about
40%). Most companies had effective tax rates well below
this, with the average effective tax rate closers to 22%.
Which tax rate drives the tax benefit of debt and why?
a. Marginal tax rates
b. Effective tax rates
¨ At the end of 2017, a tax reform act passed Congress and
became law, lowering the federal corporate tax rate from
36% to 21%? Holding all else constant, what should you
expect to see happen to debt at US companies?
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Debt adds discipline to management
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¨ If you are managers of a firm with no debt, and you
generate high income and cash flows each year, you tend
to become complacent. The complacency can lead to
inefficiency and investing in poor projects. There is little
or no cost borne by the managers
¨ Forcing such a firm to borrow money can be an antidote
to the complacency. The managers now have to ensure
that the investments they make will earn at least enough
return to cover the interest expenses.
¨ It is not the bankruptcy, per se, that makes managers
disciplined, but the loss of such a job and personal
wealth.
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Debt and Discipline
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¨ Assume that you buy into this argument that debt adds
discipline to management. Which of the following types
of companies will most benefit from debt adding this
discipline?
a. Conservatively financed (very little debt), privately
owned businesses
b. Conservatively financed, publicly traded companies,
with stocks held by millions of investors, none of whom
hold a large percent of the stock.
c. Conservatively financed, publicly traded companies,
with an activist and primarily institutional holding.
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Bankruptcy Cost
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¨ The expected bankruptcy cost is a function of two variables--
¤ the probability of bankruptcy, which will depend upon how uncertain
you are about future cash flows
¤ the cost of going bankrupt
n direct costs: Legal and other Deadweight Costs
n indirect costs: Costs arising because people perceive you to be in
financial trouble
¨ Proposition 2: Firms with more volatile earnings and cash
flows will have higher probabilities of bankruptcy at any given
level of debt and for any given level of earnings.
¨ Proposition 3: Other things being equal, the greater the
indirect bankruptcy cost, the less debt the firm can afford to
use for any given level of debt.
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Debt & Bankruptcy Cost
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¨ Rank the following companies on the magnitude of
bankruptcy costs from most to least, taking into
account both explicit and implicit costs:
a. A Grocery Store
b. An Airplane Manufacturer
c. High Technology company
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Agency Cost
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¨ An agency cost arises whenever you hire someone else to do something
for you. It arises because your interests(as the principal) may deviate from
those of the person you hired (as the agent).
¨ When you lend money to a business, you are allowing the stockholders to
use that money in the course of running that business. Stockholders
interests are different from your interests, because
¤ You (as lender) are interested in getting your money back
¤ Stockholders are interested in maximizing their wealth
¨ In some cases, the clash of interests can lead to stockholders
¤ Investing in riskier projects than you would want them to
¤ Paying themselves large dividends when you would rather have them keep the cash
in the business.
¨ Proposition 4: Other things being equal, the greater the agency problems
associated with lending to a firm, the less debt the firm can afford to use.
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