Cap Struc-1

DOES DEBT POLICY
MATTER?
What is Debt
There are only two ways in which a business can raise money.
◦ The first is debt. 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.
◦ The other is equity. With equity, you do get whatever cash flows are
left over after you have made debt payments.
The Choices
Equity can take different forms:
◦ For very small businesses: it can be owners investing their savings
◦ For slightly larger businesses: it can be venture capital
◦ For publicly traded firms: it is common stock
Debt can also take different forms

◦ For private businesses: it is usually bank loans
◦ For publicly traded firms: it can take the form of bonds
Estimating the Cost of Debt
If the firm has bonds outstanding, and the bonds are traded, the yield
to maturity on a long-term, straight (no special features) bond can be
used as the interest rate.
If the firm is rated, use the rating and a typical default spread on bonds
with that rating to estimate the cost of debt.
If the firm is not rated,
 and it has recently borrowed long term from a bank, use the interest
rate on the borrowing or
The cost of debt has to be estimated in the same currency as the cost of
equity and the cash flows in the valuation.
Effect of Financial Leverage on
Competitive Tax-free Economy
Modigliani & Miller
◦ When firm pays no taxes and capital markets function well, no difference if
firm borrows or individual shareholders borrow
◦ Hence market value of company does not depend on capital structure

M&M Debt Policy Does Not Matter
M&M Debt Policy Does Not Matter
Assumptions
Assume you operate in an environment, where
(a) there are no taxes
(b) there is no separation between stockholders and managers.
(c) there is no default risk
(d) there is no separation between stockholders and bondholders
(e) firms know their future financing needs
July 01, 1998

I have a simple explanation [for the first Modigliani-Miller
proposition]. It's after the ball game, and the pizza man comes up to
Yogi Berra and he says, 'Yogi, how do you want me to cut this pizza,
into quarters?' Yogi says, 'No, cut it into eight pieces, I'm feeling
hungry tonight.' Now when I tell that story the usual reaction is,
'And you mean to say that they gave you a [Nobel] prize for that?'"

--Merton H. Miller, from his testimony in Glendale Federal Bank's
lawsuit against the U.S. government, December 1997
Kavita Spot Removers
Kavita Spot Removers
Investors Replicate Kavita's
Leverage
Financial Risk and Expected
Returns
Proposition I and Kavita
Returns
Leverage and Returns
Returns
Proposition II and MM
Returns
Proposition II and MM
Leverage and Risk
Kavita Shares
Leverage and Cost of Equity
Returns
Weighted-Average Cost Of
Capital
Weighted-Average Cost of Capital (WACC)
Weighted-Average Cost Of
Capital
r
rE
rA = WACC
rD
D
V
WACC Traditional View
Final Word on After-Tax Weighted-
Average Cost of Capital
After-Tax WACC
◦ Tax benefit from interest-expense deductibility must include cost of funds
◦ Tax benefit reduces effective cost of debt by factor of marginal tax rate
Jet Airways
◦ Firm has marginal tax rate of 34%
◦ Cost of equity 27.44%
◦ Pretax cost of debt 14%
◦ Given book-and-market value balance sheet
what is tax-adjusted WACC?
Jet Airways
◦ WACC = (1 – .34) x 14 x .77 + 27.44 x .23 =
13.21%
After-Tax WACC
◦ Kate’s Café has marginal tax rate of 35%
◦ Cost of equity 10.0% and pretax cost of debt
5.5%
◦ Given book- and market-value balance sheets,
what is tax-adjusted WACC?
After-Tax WACC
Balance Sheet (Market Value, billions)
Assets 22.6 7.6 Debt
15 Equity
Total assets 22.6 22.6 Total liabilities
After-Tax WACC
◦ Debt ratio = (D/V) = 7.6/22.6 = .34 or 34%
◦ Equity ratio = (E/V) = 15/22.6 = .66 or 66%
Final Word on After-tax
Weighted-Average Cost Capital
After-Tax WACC
Is there an optimal capital structure?
The Empirical Evidence
The empirical evidence on whether leverage affects value is mixed.
◦ Bradley, Jarrell, and Kim (1984) note that the debt ratio is lower for firms with
more volatile operating income and for firms with substantial R&D and
advertising expenses.
◦ Barclay, Smith and Watts (1995) looked at 6780 companies between 1963 and
1993 and conclude that the most important determinant of a firm's debt ratio
is its' investment opportunities. Firms with better investment opportunities
(as measured by a high price to book ratio) tend to have much lower debt
ratios than firms with low price to book ratios.
Smith(1986) notes that leverage-increasing actions seem to be

accompanied by positive excess returns while leverage-reducing actions
seem to be followed by negative returns. This is not consistent with the
theory that there is an optimal capital structure, unless we assume that
firms tend to be under levered.
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.
The Debt Equity Trade Off
Across the Life Cycle
Stage 1 Stage 2 Stage 3 Stage 4 Stage 5
Start-up Rapid Expansion High Growth Mature Growth Decline
Revenues
$ Revenues/
Earnings
Earnings
Time
Zero, if Low, as earnings Increase, with High High, but

Tax Benefits losing money are limited earnings declining
Added Disceipline Low, as owners Low. Even if Increasing, as High. Managers are Declining, as firm
of Debt run the firm public, firm is managers own less separated from does not take many
closely held. of firm owners new investments
Bamkruptcy Cost Very high. Firm has Very high. High. Earnings are Declining, as earnings Low, but increases as
no or negative Earnings are low increasing but still from existing assets existing projects end.
earnings. and volatile volatile increase.
Very high, as firm High. New High. Lots of new Declining, as assets
Agency Costs has almost no investments are investments and in place become a Low. Firm takes few
assets difficult to monitor unstable risk. larger portion of firm. new investments
Very high, as firm High. Expansion High. Expansion Low. Firm has low Non-existent. Firm has no
Need for Flexibility looks for ways to needs are large and needs remain and more predictable new investment needs.
establish itself unpredicatble unpredictable investment needs.
Costs exceed benefits Costs still likely Debt starts yielding Debt becomes a more Debt will provide
Net Trade Off Minimal debt to exceed benefits. net benefits to the attractive option. benefits.
Mostly equity firm
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.
This approach can lead to sub-optimal leverage, if firms within a
business do not share common characteristics.
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.
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

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DOES DEBT POLICY

Debt can also take different forms

◦ Hence market value of company does not depend on capital structure

Smith(1986) notes that leverage-increasing actions seem to be

Zero, if Low, as earnings Increase, with High High, but

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