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Brief Overview of Debt and Equity. The Only Two Choices for Financing. Debt (Leverage) The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business. Equity

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the only two choices for financing
The Only Two Choices for Financing
  • Debt (Leverage)
    • The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.
  • Equity
    • With equity, you do get whatever cash flows are left over after you have made debt payments.
when is it debt
When Is It Debt?
  • Ask 3 Questions:
  • Is the cashflow claim created by this financing a fixed commitment or a residual claim?
  • Is the commitment tax-deductible?
  • If you fail to uphold the commitment, do you lose control of the business?
  • If all three answers are “Yes”, it’s debt. Otherwise, it’s equity or a hybrid.
cost of debt
Cost of Debt

Debt is always the least costly form of financing.

WHY?

cost of debt vs equity
Cost of Debt vs. Equity

E(R)

Debt will always be perceived by investors to be less risky than equity. Therefore, its required return will always be lower.

Equity

Rf

Debt

β

the choices
The Choices
  • Equity can take different forms:
    • Small business owners investing their savings
    • Venture capital for startups
    • Common stock for corporations
  • Debt can also take different forms
    • For private businesses, it is usually bank loans
    • For publicly traded firms, it is more likely to be debentures (bonds) for long-term debt and commercial paper for short-term debt
compare advantages and disadvantages of debt
Compare Advantages and Disadvantages of Debt

Advantages of Debt

  • Interest is tax-subsidized  Low cost
  • Increases upside variability of cashflows to equity
  • Adds discipline to management

Disadvantages of Debt

  • Possibility of bankruptcy/financial distress
  • Increases downside variability of cashflows to equity
  • Agency costs are incurred
  • Loss of future flexibility
what does leverage mean
What Does Leverage Mean?

Depending on where the fulcrum is placed, a small force can be amplified into a much larger force.

what does leverage mean11
What Does Leverage Mean?

In financial leverage, the fulcrum is the fixed cost of the debt financing.

The small force is variability of operating income.

The large force is the variability of cashflows to shareholders (EPS)

what does leverage mean12
What Does Leverage Mean?

The larger the fixed interest payments…

The more a small change in operating profit…

Will be amplified into a larger change in EPS

what managers consider important in deciding on how much debt to carry
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

FactorRanking (0-5)

1. Maintain financial flexibility4.55

2. Ensure long-term survival4.55

3. Maintain Predictable Source of Funds4.05

4. Maximize Stock Price3.99

5. Maintain financial independence3.88

6. Maintain high debt rating3.56

7. Maintain comparability with peer group2.47

why does the capital structure mix matter
Why does the Capital Structure Mix matter?
  • Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.
  • If the cash flows to the firm are held constant and the cost of capital is minimized, the value of the firm will be maximized.

So, if capital structure changes do not affect the cost of capital, then capital structure is irrelevant since it will not affect firm value.

the most realistic view of capital structure16
The Most Realistic View of Capital Structure…

The tax advantage of debt would be progressively offset by the rising potential for bankruptcy and the resulting financial distress costs, and also by the rising agency costs.

The result would be that the WACC would fall as debt went from zero to some larger amount, but would eventually reach a minimum and then start to climb.

Thus, there would be an optimal capital structure where the WACC is minimized. This would be less that 100% debt.