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The Capital Structure Decision: Theory. P.V. Viswanath. Based on Damodaran’s Corporate Finance. 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. Tax Benefits of Debt.

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the capital structure decision theory

The Capital Structure Decision: Theory

P.V. Viswanath

Based on Damodaran’s Corporate Finance

costs and benefits of debt
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

P.V. Viswanath

tax benefits of debt
Tax Benefits of Debt
  • 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:
    • Tax benefit each year = Tax Rate * Interest Payment

P.V. Viswanath

tax benefit proposition
Tax Benefit Proposition
  • 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.

P.V. Viswanath

the effects of taxes
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

P.V. Viswanath

implications of the tax benefit of debt
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. In supporting evidence,
  • 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.
  • Although it is always difficult to compare debt ratios across countries, 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.

P.V. Viswanath

debt adds discipline to management
Debt adds discipline to management
  • 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. The cost of not doing so is bankruptcy and the loss of such a job.

P.V. Viswanath

debt and discipline
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.

P.V. Viswanath

empirical evidence on the discipline of debt
Empirical Evidence on the Discipline of Debt
  • Firms that are acquired in hostile takeovers are generally characterized by poor performance in both accounting profitability and stock returns.
  • There is evidence that increases in leverage are followed by improvements in operating efficiency, as measured by operating margins and returns on capital.
    • Palepu (1990) presents evidence of modest improvements in operating efficiency at firms involved in leveraged buyouts.
    • Kaplan(1989) and Smith (1990) also find that firms earn higher returns on capital following leveraged buyouts.
    • Denis and Denis (1993) study leveraged recapitalizations and report a median increase in the return on assets of 21.5%.

P.V. Viswanath

bankruptcy cost
Bankruptcy Cost
  • The expected bankruptcy cost is a function of two variables-
    • the cost of going bankrupt
      • direct costs: Legal and other Deadweight Costs
      • indirect costs: Costs arising because people perceive you to be in financial trouble
    • the probability of bankruptcy, which will depend upon how uncertain you are about future cash flows
  • As you borrow more, you increase the probability of bankruptcy and hence the expected bankruptcy cost.

P.V. Viswanath

indirect bankruptcy costs should be highest for
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

P.V. Viswanath

the bankruptcy cost proposition
The Bankruptcy Cost Proposition
  • Proposition 2: Other things being equal, the greater the indirect bankruptcy cost and/or probability of bankruptcy in the operating cashflows of the firm, the less debt the firm can afford to use.

P.V. Viswanath

debt bankruptcy cost
Debt & Bankruptcy Cost

Rank the following companies on the magnitude of bankruptcy costs from most to least, taking into account both explicit and implicit costs:

  • A Grocery Store
  • An Airplane Manufacturer
  • High Technology company

P.V. Viswanath

implications of bankruptcy cost proposition
Implications of Bankruptcy Cost Proposition
  • Firms operating in businesses with volatile earnings and cash flows should use debt less than otherwise similar firms with stable cash flows.
  • If firms can structure their debt in such a way that the cash flows on the debt increase and decrease with their operating cash flows, they can afford to borrow more.
  • If an external entity, such as the government or an agency of the government, provides protection against bankruptcy through either insurance or bailouts for troubled firms, firms will tend to borrow more.
  • Firms with assets that can be easily divided and sold should borrow more than firms with assets that are less liquid.

P.V. Viswanath

agency cost
Agency Cost
  • 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 your 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.

P.V. Viswanath

agency cost proposition
Agency Cost Proposition
  • 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.

P.V. Viswanath

debt and agency costs
Debt and Agency Costs

Assume that you are a bank. Which of the following businesses would you perceive the greatest agency costs?

  • A Large Pharmaceutical company
  • A Large Regulated Electric Utility


P.V. Viswanath

how agency costs show up
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, which increases as the covenants become more detailed and restrictive.
    • the indirect cost of lost investments, since the firm is not able to take certain projects, use certain types of financing, or change its payout; this cost will also increase as the covenants becomes more restrictive.

P.V. Viswanath

implications of agency costs
Implications of Agency Costs..
  • The agency cost arising from risk shifting is likely to be greatest in firms whose investments cannot be easily observed and monitored. These firms should borrow less than firms whose assets can be easily observed and monitored.
  • The agency cost associated with monitoring actions and second-guessing investment decisions is likely to be largest for firms whose projects are long term, follow unpredictable paths, and may take years to come to fruition. These firms should also borrow less.

P.V. Viswanath

loss of future financing flexibility
Loss of future financing flexibility
  • When a firm borrows up to its capacity, it loses the flexibility of financing future projects with debt.
  • Proposition 4: 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.

P.V. Viswanath

debt summarizing the trade off
Debt: Summarizing the Trade Off

Advantages of Borrowing

Disadvantages of Borrowing

1. Tax Benefit:

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

P.V. Viswanath

6 application test would you expect your firm to gain or lose from using a lot of debt
6Application Test: Would you expect your firm to gain or lose from using a lot of debt?
  • 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?

P.V. Viswanath