The Financing Mix

1. The Financing Mix 02/23/06

2. The financing mix question • 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? • If not, why not?

3. Costs and benefits of debt • Benefits of Debt • Tax Benefits • Adds discipline to management • Costs of Debt • Bankruptcy Costs • Agency Costs • Loss of Future Flexibility

4. Tax benefits of debt • Interest paid on debt is tax deductible, whereas cash flows to equity have to be paid out of after-tax cash flows. • The dollar tax benefit from the interest payment in any year is a function of your tax rate and the interest payment: Tax benefit each year = Tax Rate * Interest Payment

5. The effects of taxes 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?  The real estate corporations  The real estate investment trusts  Cannot tell, without more information

6. Implications of the tax benefit of debt • The debt ratios of firms with higher tax rates should be higher than the debt ratios of comparable firms with lower tax rates. • Firms that have substantial non-debt tax shields, such as depreciation, should be less likely to use debt than firms that do not have these tax shields. • If tax rates increase over time, we would expect debt ratios to go up over time as well, reflecting the higher tax benefits of debt. • We would expect debt ratios in countries where debt has a much larger tax benefit to be higher than debt ratios in countries whose debt has a lower tax benefit.

7. Debt adds discipline to management • Free cash flow (or cash flow to equity) represents cash flow from operations after all obligations have been paid. • It represents cash flow for which management has discretionary spending power. • Without discipline, management may make wasteful investments with free cash flow because they do not bear any costs for making these investments. • Forcing firms with free cash flow to borrow money can be an antidote to managerial complacency. • Empirical evidence is consistent with the hypothesis that increasing debt improves firm performance.

8. Debt and discipline 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?  Conservatively financed (very little debt), privately owned businesses  Conservatively financed, publicly traded companies, with stocks held by millions of investors, none of whom hold a large percent of the stock.  Conservatively financed, publicly traded companies, with an activist and primarily institutional holding.

9. Bankruptcy cost • Bankruptcy is when a firm is unable to meet its contractual commitments. • The expected bankruptcy cost is a function of two variables-- • the cost of going bankrupt • direct costs: Legal and other administrative costs (1-5% of asset value) • indirect costs: Costs arising because people perceive you to be in financial trouble – loss of revenue, stricter supplier terms, capital raising difficulties • the probability of bankruptcy, which is a function of the size of operating cash flows relative to debt obligations and the variance in operating cash flows • As you borrow more, you increase the probability of bankruptcy and hence the expected bankruptcy cost.

10. Indirect bankruptcy costs should be highest for…. • Firms that sell durable products with long lives that require replacement parts and service • Firms that provide goods or services for which quality is an important attribute but where quality difficult to determine in advance • Firms producing products whose value to customers depends on the services and complementary products supplied by independent companies • Firms that sell products requiring continuous service and support from the manufacturer

11. The bankruptcy cost proposition and implications • Proposition: • Other things being equal, the greater the indirect bankruptcy cost and/or probability of bankruptcy in the operating cash flows of the firm, the less debt the firm can afford to use. • Implications: • Firms operating in businesses with volatile earnings and cash flows should use debt less than otherwise similar firms with stable cash flows. • Firms with assets that can be easily divided and sold should borrow more than firms with assets that are less liquid.

12. Agency cost (conflict between stockholder and bondholder) • 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

13. Agency cost (conflict between stockholder and bondholder) • 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.

14. Agency cost proposition • Other things being equal, the greater the agency problems associated with lending to a firm, the less debt the firm can afford to use.

15. What firms are most affected by agency cost? • Agency costs will tend to be the greatest in firms whose investments cannot be easily monitored or observed • Agency costs will tend to be the greatest for firms whose projects are long-term, unpredictable or will take years to come to fruition.

16. How agency costs show up... • If bondholders believe there is a significant chance that stockholder actions might make them worse off, they can build this expectation into bond prices by demanding much higher rates on debt. • If bondholders can protect themselves against such actions by writing in restrictive covenants, two costs follow – • the direct cost of monitoring the covenants • the indirect cost of lost investments

17. Loss of future financing flexibility • When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt. • Financing Flexibility Proposition: • Other things remaining equal, the more uncertain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects.

18. 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

19. Debt: Summarizing the Trade Off Advantages of Borrowing Disadvantages of Borrowing 1. TaxBenefit: 1. Bankruptcy Cost: Higher tax rates --> Higher tax benefit Higher business risk --> Higher Cost 2. Added Discipline: 2. Agency Cost: Greater the separation between managers Greater the separation between stock- and stockholders --> Greater the benefit holders & lenders --> Higher Cost 3. Loss of Future Financing Flexibility: Greater the uncertainty about future financing needs --> Higher Cost

20. A qualitative analysis of the firm’s debt ratio • Tax benefits: • What is the firm’s tax rate? • Does the company have substantial tax shields? • Discipline: • Does management own shares? • Does the firm have significant free cash flows? • Bankruptcy: • How volatile are the firm’s earnings and cash flows? • How liquid and divisible are the firm’s assets? • Agency: • Are the firm’s investments easily monitored? • Are the investments short term or long term? • Financial Flexibility: • What stage of life cycle is the firm in?

21. A Qualitative Analysis

22. The Miller-Modigliani Theorem • Assume you operate in an environment, where • there are no taxes • there is no separation between stockholders and managers. • there is no default risk • there is no separation between stockholders and bondholders • firms know their future financing needs

23. The Miller-Modigliani Theorem • Then, • The value of a firm is independent of its debt ratio • Implications: • Leverage is irrelevant. A firm's value will be determined by its project cash flows. • The cost of capital of the firm will not change with leverage. As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage

24. The Miller-Modigliani Theorem with taxes • When taxes are introduced, with no costs to debt, the optimal debt level for a firm is 100%. • Value of firm with perpetual debt (B) and a tax rate of t: Value = Value of all-equity (unlevered) firm + tB where tB is the present value of tax savings from debt

25. Can debt be irrelevant in a world with taxes? • In the presence of personal taxes on both interest income and income from equity, it can be argued that debt could still be irrelevant if the cumulative taxes paid (by the firm and investors) on debt and equity are the same. • Thus, if td is the personal tax rate on interest income received by investors, te is the personal tax rate on income on equity and tc is the corporate tax rate, debt will be irrelevant if: (1 - td) = (1-tc) (1-te)

26. Is there an optimal capital structure? • When marginal benefits and costs of taking on debt are considered, an optimal capital structure exists where these two are equal. • The empirical evidence on whether leverage affects value is mixed.

27. How do firms set their financing mixes? • Life Cycle: Some firms choose a financing mix that reflects where they are in the life cycle; start- up firms use more equity, and mature firms use more debt. • Comparable firms: Many firms seem to choose a debt ratio that is similar to that used by comparable firms in the same business. • Financing Heirarchy: Firms also seem to have strong preferences on the type of financing used, with retained earnings being the most preferred choice. They seem to work down the preference list, rather than picking a financing mix directly.

28. Comparable firms • When we look at the determinants of the debt ratios of individual firms, the strongest determinant is the average debt ratio of the industries to which these firms belong. • This is not inconsistent with the existence of an optimal capital structure. If firms within a business share common characteristics (high tax rates, volatile earnings etc.), you would expect them to have similar financing mixes.

29. Rationale for financing hierarchy • Managers value flexibility. External financing reduces flexibility more than internal financing. • Managers value control. Issuing new equity weakens control and new debt creates bond covenants.

30. Preference rankings : Results of a survey Ranking Source Score 1 Retained Earnings 5.61 2 Straight Debt 4.88 3 Convertible Debt 3.02 4 External Common Equity 2.42 5 Straight Preferred Stock 2.22 6 Convertible Preferred 1.72

31. Financing Choices You are reading the Wall Street Journal and notice a tombstone ad for a company, offering to sell convertible preferred stock. What would you hypothesize about the health of the company issuing these securities?  Nothing  Healthier than the average firm  In much more financial trouble than the average firm