Financing Decisions and The Cost of Capital. Where do Firms Get Their Money?. Self Financing (using internal cash flow) Accounts for 80% (avg.) of financing Difficult for start-up companies External Financing Borrowing from banks or issuing bonds
Uses of Cash Flow (100%)
Sources of Cash Flow (100%)
Capital spending 80%
Internal cash flow (retained earnings plus depreciation) 70%
Internal cash flow
Net working capital plus other uses 20%
Long-term debt and equity 30%
External cash flow
Source: 1987 SBA survey of firms with less than $500,000 in assets.
Small with growth potential
Large with Track record
Very small, no track record
Inside seed money
Short-term commercial loans
Intermediate-term commercial loans
Source: FRB Report on Private Placements, Rea et. al., 1993
Senior to equity
Interest is deductible
Only get control rights in default
Uncertain residual cash flows
Dividends are not deductible
Comes with control rights (can vote)What is the Difference Between Debt and Equity?
Let the expected return on the underlying assets be 9% and the
cost of debt be 6%.
Cost of capital: r (%)
Cost of capital: r(%)
the value of an equivalent but unlevered firm
+ present value of tax shields (net)
– present value of expected bankruptcy costs and agency costs.
shield on debt
The Value of the Firm with Costs
of Financial Distress
Value of firm (V)VL = VU +TC B = Value of firm under
MM with corporate
Maximum taxes and debt
V= Actual value of firm
VU= Value of firm with no debt
Optimal amount of debt
The tax shield increases the value of the levered firm. Financial distress
costs lower the value of the levered firm. The two offsetting factors produce
an optimal amount of debt.
Present value of financial distress costs
If you recall, BK was evaluating a project in a very different industry from its own with the following incremental cash flows (FCF). At 10% we found an NPV of $5.2 million.
Recalling that BK will keep its debt/equity
ratio equal to one, we can get:
The weighted average cost of capital for the text editing venture (using the fact that B/S = 1) is:
= +$3.79 m.