Capital Structure: Overview

of the Financing Decision

05/12/08
Ch. 7
Corporate finance decisions revisited
 Corporate finance consists of three major
decisions:
 Investment decision

 The financing decision

 Where do firms raise the funds for value-creating
investments?
 What mix of owner’s money (equity) or borrowed
money(debt) should the firm use?

 Dividend decision
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Measuring a firm’s financing mix
 The simplest measure of how much debt and equity a firm is
using currently is to look at the proportion of debt in the total
financing. This ratio is called the debt to capital ratio (or simply
the debt ratio):

Debt to Capital Ratio = Debt / (Debt + Equity)

 Debt includes all interest bearing liabilities, short term as well as

long term.

 Equity can be defined either in accounting terms (as book value

of equity) or in market value terms (based upon the current
price). The resulting debt ratios can be very different.
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 Debt versus Equity
•The differences between debt and equity lies in the nature of the stakeholders’
claims on the firm’s cash flows, tax treatment, maturity and voting power

Debt versus Equity

Fixed Claim Residual Claim

High Priority on cash flows Lowest Priority on cash flows
Tax Deductible Not Tax Deductible
Fixed Maturity Infinite life
No Management Control Management Control

Debt Hybrids (Combinations Equity

of debt and equity)

4
Equity choices for private firms
 Private firms have fewer choices for raising
equity capital

 Owner’s Equity
 Retention and plow back of company’s
earnings
 Similar in nature to retained earnings of a
public company in terms of taxability, residual
claim, management control

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Equity choices for private firms
 Venture Capitalist
 VCs provide equity financing to small and risky
businesses in return for a share in ownership of the
firm

 VC ownership is a function of
 Capital contribution

 Financing options available to the business

 VC provides
 Managerial and organizational skills

 Credibility of venture to potential capital providers

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Equity choices for public firms
 The public firm has more alternatives for
raising equity

 Common Stock
 Initial public offerings (IPOs) – raising equity
capital publicly for the first time
 Seasoned equity offerings (SEOs) –
subsequent issues of common stock

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Equity choices for public firms
 Common Stock
 Firms may issue common stock that is uniform
in offering price and voting rights or;
 Firms may create classes of shares to:
 Create differential voting rights so that owners
maintain control of the firm
 Cater to different clientele that are in different tax
brackets

 Common stock issues tend to decline as a

means of raising capital as the firm matures
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Equity choices for public firms
 Tracking stock
 Stock issued against specific assets or
portions of the firm
 May allow investors to buy portions of a firm
that have the greatest potential
 Typically do not provide investors with voting
rights

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Equity choices for public firms
 Warrants
 Provides investors with the option to buy
equity at a fixed price in the future in return for
paying for the warrants today

 Can be attractive because

 No immediate financial obligation to firm
 No immediate dilution of ownership

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Debt financing options
 Bank debt
 Borrowing from a bank at an interest rate
charged by the bank based on the borrowing
firm’s perceived risk

 Advantages of bank debt (versus bonds):

 Can be issued in small amounts
 Allows firm to maintain proprietary information
 Does not require being rated

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Debt financing options
 Bonds
 Borrowing from the public by issuing debt

 Advantages of bonds
 Typically carry more favorable terms than bank debt
 Allows issuers to add on special features

 When issuing bonds, firms have to make a variety of

choices including maturity, fixed or floating interest
payment, secured or unsecured.

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Debt financing options
 Leasing
 Firm (lessee) commits to making fixed
payments to the owner (lessor) for the right to
use the asset
 Payments may be fully tax deductible

 Provides firms with an alternative to buying

capital assets

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Debt financing options
 Leasing
 Operating lease
 Shorter term

 present value of the lease payments is generally much

lower than the price of asset
 Ownership resides with the lessor

 Lease expense is treated as an operating expense

 Off-balance sheet financing

 Capital lease
 Lasts the lifetime of the asset

 Lessee is responsible for insurance and taxes on the

asset
 For tax purposes, capital leases are equivalent to
borrowing and buying the asset, consequently,
depreciation and interest expense are shown as 14

expenses on the income statement

Debt financing options
 Leasing
 Reasons provided for leasing
 Firm has insufficient borrowing capacity

 Bond covenants restrict firms from taking on more

conventional debt

 Operating leases tend to provide firms with greater

profitability ratios since operating expense will typically be
lower than if the asset was purchased and the lease is not
included as part of the firm’s capital

 Differential tax rates – an entity with a higher tax rate will

benefit more from buying the asset. This high-tax entity can
then lease the asset to a lower / no tax entity and can share
the tax benefits

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Debt financing options
 Leasing
 The decision to lease or borrow/buy should be
based on the incremental after-tax cash flows

 Operating lease cash flows:

Lease payments * (1 – t)

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Debt financing options
 Leasing
 Borrow/Buy cash outflows
 Interest expense (after tax)
 Principal payments (non-tax deductible)
 Maintenance expenses (after tax)

 Borrow/Buy cash inflows

 Depreciation tax benefit (t*Depreciation)
 Salvage value (after tax)

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Debt financing options
 Leasing
 The net advantage to leasing

NPV of lease option – NPV of buy option

Where cash flows are discounted at the after tax

cost of debt since both represent borrowing
alternatives and cash flows are calculated on
an after-tax basis

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Hybrid securities
 Financing choices that have characteristics of
both debt and equity are referred to as hybrid
securities

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Hybrid securities
 Convertible debt
 Can be converted by the bondholder to a
predetermined number of shares of common stock

 The conversion option:

 Conversion ratio = number of shares for which each

bond may be exchanged

 Conversion value = current value of shares for which

the bonds can be exchanged

 Conversion premium = excess of bond price over

conversion value

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Hybrid securities
 Convertible debt
 Reasons for issuing convertible debt
 Investors will require a lower required return, thus
allowing firms to set a lower coupon rate
 Particularly useful for high-growth companies

 Reduces the conflict between equity and bond

holders

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Hybrid securities
 Preferred stock
 Generates fixed payment obligations by the
firm
 Cost more to raise than debt

 Reasons for issue

 Analysts and rating agencies treat preferred stock
as equity for calculating leverage

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Financing
 We now look at the distinction between
internal and external financing and the factors
that affect how much firms draw on each
source and how firms decide between their
external financing choices.

 Internal Financing – funds raised from cash

flows of existing assets
 External Financing – funds raised from
outside the company (VC, debt, equity, etc.)

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Internal vs. External Financing
 Firms may prefer internal financing because
 External financing is difficult to raise
 External financing may result in loss of control
 Raising external capital tends to be expensive

 Projects funded by internal financing must

meet same hurdle rates

 Internal financing is limited

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A Life Cycle View of Financing
Choices
Reven ues
$ Rev enu es /
Earnin gs

Earnin gs

Time

External fund ing High , bu t High , relative Mod erate, relative Declin ing, as a
need s Lo w, as pro jects dry
cons train ed by to firm value. to firm value. percent o f firm
up .
in fras tructu re value

Internal financing Neg ativ e o r Neg ativ e o r Lo w, relativ e to High , relative to More than fu ndin g need s
lo w lo w fun ding needs fun ding needs

External Owner’s Eq uity Venture Cap ital Common stock Deb t Retire deb t
Fina ncin g Bank Debt Common Stock Warrants Repurchas e stock
Con vertibles

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expan sio n High Growth Mature Growth Declin e 25
Fina ncin g
Tran sitio ns Acces sin g private equity Inital Public offering Seas oned equity is su e Bon d is su es
Process of raising capital
 Private firm expansion

 From private to public firm: The IPO

 Choices for a public firm

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VC process
 Provoke equity investors’ interest
 There is an imbalance between the number of small
firms that desire VC investment and the number of VCs

 Firms need to distinguish themselves from others to

obtain VC funding

 Type of business
 Dot.com in the 90s, bio-tech firms this decade

 Successful management

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VC process
 Perform valuation and return assessment (Venture capital
method)
 Estimate earnings in the year the company is expected to go
public

 Obtain a P/E multiple for public firms in the same industry

Exit or Terminal Value = P/E multiple * forecasted earnings

 Discount this terminal value at the VC’s target rate of return

Discounted Terminal Value = Estimated exit value

(1 + target return)n

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VC process
 Structure the deal
 Determine the proportion of firm value that VC
will get in return for investment
Ownership Proportion = Capital Provided
Disc. Exit Value

 VC will establish constraints on how the

managers run the firm

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VC process
 Participate in post-deal management
 VCs provide managerial experience and contacts for
additional fund raising efforts

 Exit
 VCs generate a return on their investment by exiting
the investment.
 They can do so through
 An initial public offering

 Selling the business to another firm

 Withdrawing firm cash flows and liquidating the firm

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VC process
 Stages of Venture Capital Investments
 Seed financing is capital provided at the “idea”
stage.
 Start-up financing is capital used in product
development.
 First-stage financing is capital provided to initiate
manufacturing and sales.
 Second-stage financing is for initial expansion.
 Third-stage financing allows for major expansion.
 Mezzanine financing prepares the company to go
public.

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Going public vs. staying private
 The benefits of going public are:
 Firms can access financial markets and tap
into a much larger source of capital
 Owners can cash in on their investments

 The costs of going public are:

 Loss of control
 Information disclosure requirements
 Exchange listing requirements
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Initial Public Offering (IPO) process
 Most public offerings are made with the assistance of
investment bankers (IBs) which are financial
intermediaries that specialize in selling new securities
and advising firms with regard to major financial
transactions.

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IPO process
 The role of the investment banker
 Origination - design of a security contract that is acceptable
to the market;
 prepare the state and federal Securities and Exchange
Commission (SEC) registration statements and a summary
prospectus,

 Underwriting-the risk-bearing function in which the IB buys

the securities at a given price and turns to the market to sell
them.
 Syndicates are formed to reduce the inventory risk.

 Sales and distribution-selling quickly reduces inventory risk.

Firm members of the syndicate and a wider selling group
distribute the securities over a wide retail and institutional
area.

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IPO process

35
IPO process
 IPO costs

 Underwriting commission (usually around 7%)

 Underpricing of issue
 Represents the first day returns generated by the firm,
calculated as
Closing Price – Offer price
Offer price

 Issues are underpriced to

 Provide investors with a “good taste” about the investment banker
and firm
 Compensate investors for the information asymmetry between
firm and investor

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IPO process
 Valuing the company and setting issue details
 Investment banker and firm need to determine
 Value of company
 Valuation is typically done using P/E multiples
 Size of the issue
 Value per share
 Offering price per share
 This will tend to be below the value per share, i.e.,
the offer will be underpriced

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IPO process
 Determining the offer price
 The investment banker will gauge the level of
interest from institutional investors for the
issue by conducting road shows. This is
referred to as building the book.

 After the offer price and issue details are set,

and the SEC has approved the registration,
the firm places a tombstone advertisement
in newspapers, that outlines the details of the
issue and the investment bankers involved
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IPO process
 Waiting period – The period between the submission
of the registration to the SEC and the SEC’s
approval. It is during this time that the company
releases the red herring

 Quiet period – a period after the registration is

submitted until approximately a month after the issue
where the company cannot comment on the
earnings, prospects for the company

 Lock-up period – a period of usually 6 months

following the issue date in which the insiders of the
company cannot sell their shares

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Choices for a publicly traded firm
 General subscription (or Seasoned Equity
Offering)

 Private placements

 Rights offerings

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General subscription (SEO)
 Although for IPOs the underwriting agreement almost
always involves a firm guarantee from the underwriter
to purchase all of the issue, in secondary offerings,
the underwriting agreement may be a best efforts
guarantee where the underwriter sells as much of
the issue as he can

 SEOs tend to have lower underwriting commissions

because of IB competition.

 The issuing price of an SEO tends to be set slightly

lower than the current market price
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Private placement
 Securities are sold directly to one or few
investors

 Saves on time and cost (no registration

requirements, marketing needs)

 Tends to be less common with corporate

equity issues. Private placement is used more
in corporate bond issues.
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Rights offerings
 Existing investors are provided the right to purchase
additional shares in proportion to their current
holdings at a price (subscription price) below
current market price (rights-on price)

 Each existing share is provided one right.

 The number of rights required to purchase a share in

the rights offering is then determined by the number
of shares outstanding and the additional shares to be
issued in the rights offering.

rights required to purchase one share = # of original shares

# of shares issued in RO
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Rights offerings
 Because investors can purchase shares at a lower price, the rights
have value:

Value of the right = rights-on price – subscription price

n+1

where n = number of rights required for each new share

 Because additional shares are issued at a price below market price, the
market price will drop after the rights offering to the ex-rights price

ex-rights price = New value of equity

New number of shares

 The value (or price) of the right can also be calculated as:

rights-on price – ex-rights price

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Rights offerings
 Costs are lower because of
 Lower underwriting commissions – rights offerings tend
to be fully subscribed
 Marketing and distribution costs are significantly lower

 No dilution of ownership

 No transfer of wealth

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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?

46
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

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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

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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

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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.

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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 51

increasing debt improves firm performance.
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.
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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. 53
Indirect bankruptcy costs should be
highest for….
 Firms that sell durable products with long
lives that require replacement parts and
service

 Firms producing products whose value to

customers depends on the services and
complementary products supplied by
independent companies

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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.
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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

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Agency cost (conflict between
stockholder and bondholder)
 In some cases, the conflict 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.

57
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.

58
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.

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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

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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.

61
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

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Debt: Summarizing the Trade Off
Advantages of Borrowing
1. Tax Benefit:
Higher tax rates --> Higher tax benefit
2. Added Discipline:
Greater the separation between managers
and stockholders --> Greater the benefit
Disadvantages of Borrowing
1. Bankruptcy Cost:
Higher business risk --> Higher Cost
2. Agency Cost:
Greater the separation between stock-
holders & lenders --> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future
financing needs --> Higher Cost
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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?
 How would you assess the firm’s indirect bankruptcy costs
(perception of the consumer)?
 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?

64
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.

65
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.

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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.

67
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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