Long term Financing

Capital Structure
http://forbesindia.com/article/boardroom/ho
w-srei-infra-recovered-money-from-
kingfisher-airlines/38339/1
Todays Lecture
Long term Financing
Capital Structure
Does Debt Policy Matter?
Modigliani and Miller (M&M)
Financing Theories
First principles
 Clay Tablets as Financial Assets
4000 years ago, ancient Mesopotamia

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 Another tablet
A debt of 4 measures of Barley should be repaid
to bearer of the tablet

CONFIDENCE OF PEOPLE IN INSTRUMENTS

Promises to pay

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 What revolutionized the world?
IDEA OF BORROWING
Credit comes from CREDO in Latin which means
I believe
MONEY LENDERS VENICE
Christians could not charge interests on credit but
Jews could.
Sit on Banci (Italian) and do the transaction
Shylock in Shakespeares Merchant of Venice

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 Offers to loan the money
without interest, provided
Antonio will sign a bond
pledging himself 'in a
merry sport' to allow the
Jew to cut a pound of his
flesh on payment day,
should the necessary sum
not be forthcoming.

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 Portia decrees the rabid Jew shall have his pound
of flesh, whereupon Shylock, almost beside
himself with revengeful fury, starts forward to
claim it.
But his advance is checked by the judge gravely
warning him that, whereas the flesh is his, he
must not shed a single drop of blood, there being
a law in Venice to the effect that should a Jew
attempt to shed Christian blood, he forfeits his
estates!

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 Risky to be a money lender
Could survive if they get bigger
The Medici in 15th Century Italy
Legitimate, glorious
Paid for renaissance
Foreign exchange dealers
No interest but commission
Diversification to get bigger

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History of Debt
The first 500 years David Graeber
Morality Confusion
Ancient Buddhists
Biblical Route Noah

Debt Revolts Roman constitutions

Freedom originally meant debt freedom
Islam and Christianity outlawed the taking of interest
entirely.
Buddhism was always more tolerant of debt--though
Buddhist monasteries in China were among the first to
promulgate the pawn shop, as a way of giving the poor an
alternative to the local loan-shark
Financing Choices
Assessing the existing Financing
Choices
 Internal Vs. External Financing
For private firms,
external financing is typically difficult to raise, and even
when it is available (from a venture capitalist, for
instance) it is accompanied by a loss of control (the
venture capitalist wants a share of control).
For publicly traded firms,
external financing may be easier to raise, but it is still
expensive in terms of issuance costs (especially in the
case of new equity).
Internally generated cash flows, on the other hand, can
be used to finance operations without incurring large
transaction costs or losing control.
 Despite these advantages, there are limits to the
use of internal financing to fund projects.
First, firms have to recognize that internal equity
has the same cost as external equity, before the
transaction cost differences are factored in. The
cost of equity, computed using a risk and return
model, such as the CAPM or APM, applies as
much to internal as to external equity.
 Second, internal equity is clearly limited to the cash
flows generated by the firm for its stockholders. Even
if the firm does not pay dividends, these cash flows
may not be sufficient to finance the firms projects.
Depending entirely on internal equity can therefore
result in project delays or the possible loss of these
projects to competitors.
Third, managers should not make the mistake of
thinking that the stock price does not matter just
because they use only internal equity for financing
projects. In reality, stockholders in firms whose stock
prices have dropped are much less likely to trust their
managers to reinvest their cash flows for them than
are stockholders in firms with rising stock prices.
 Financing and Growth Life Cycle Analysis of Financing

Stage III Stage IV Stage V

Stage Stage II
Revenues/Earni

I
Revenues
Mature
Growth Decline
ngs

High Earnings
Growth
Rapid
Expansion Time
Start Up

Financing
Transitions
 Financing and Growth Life Cycle Analysis of Financing

Declining
High
Revenues/Earni

Moderate Low
but
constr High Revenues
ained
by
ngs

infrast
Earnings
ructur
e

External Time
Funding Needs

Financing
Transitions
 Financing and Growth Life Cycle Analysis of Financing
Low
Negativ relative
Revenues/Earni

e or Low to
Negati funding Revenues
ve or needs High
Low relativ More
ngs

e to than Earnings
fundin funding
g needs
needs
Time
Internal
Financing

Financing
Transitions
 Financing and Growth Life Cycle Analysis of Financing
Revenues/Earni

Revenues
ngs

Earnings

Owner Venture Common Time

Debt Retire Debt
s Capital Stocks
External Repurchase
Equity Common Warrants Stock
Financing Bank Stock Convertibl
Debt es

Financing
Transitions
 Financing and Growth Life Cycle Analysis of Financing
Second Bonds
ary
Revenues/Earni

Initial
Accessi Public Equity
ng Offerin Offering Revenues
Private g
Equity
ngs

Earnings

Time

Financing Transitions
Financing and Growth
How firms have actually raised
funds?
Small, private businesses
The authors find that these firms:
1. depend almost entirely on internal financing,
owners equity, and bank debt to cover capital
needs.
2. The proportion of funds provided by internal
financing increases as the firms became older and
more established
3. Many of these firms ultimately plan on going public,
and the returns to the private equity investors come
at the time of the public offering

Fluck, Holtz-Eakin, and Rosen, 1998

G-7 Countries
Rajan, Raghuram G. and Luigi Zingales. What Do
We Know About Capital Structure? Some
Evidence From International Data, Journal of
Finance, 1995, v50(5), 1421-1460.
How firms have actually raised
funds?
 German and Japanese firms are much more
dependent on bank debt than firms in the United
States, which are much likely to issue bonds
There is also some evidence that firms in some
emerging markets, such as Brazil and India, use
equity (internal and equity) much more than debt
to finance their operations
 Firms in the United States, in contrast to firms in
emerging markets, are much more likely to be in
the mature growth stage of the life cycle.
Consequently, firms in the United States should
be less dependent on external equity.
Another factor is that firms in the United States
have far more access to corporate bond markets
than do firms in other markets.
Firms in Europe, for instance, often have to raise
new debt from banks, rather than bond markets
Measuring a firms financing mix

The simplest measure is the debt to capital ratio

Proportion of debt to total capital (debt+equity)
The Financing Mix Question
In deciding to raise financing for a business, is
there an optimal mix of debt and equity?
If yes, then what are the tradeoffs that help us
determine the mix?
Benefits and Cost of Debt vis a vis Equity
If no, then why not?
Debt
Benefits
Tax advantage
Consider a firm that borrows $B to finance it operations, on which it
faces an interest rate of r percent, and assume that it faces a
marginal tax rate of t on income.
Annual Interest Expense Arising from the Debt = rB
Annual Tax Savings Arising from the Interest Payment = trB
Present Value of Tax Savings from Debt = trB/r = tB
= Marginal Tax Rate * Debt
 A firm that borrows $100 million at 8 percent for ten
years and has a tax rate of 40 percent
Present Value of Interest Tax Savings = Annual Tax
Savings (PV of Annuity)
= (0.08 * 0.4 * $100 million) (PV of Annuity, 8%, 10
years) = $21.47 million
When asked to analyze the effect of adding debt on
value, some analysts use a shortcut and simply add
the tax benefit from debt to the value of the firm with
no debt:
Value of Levered Firm with Debt B = Value of
Unlevered Firm + tB
Tax benefit from debt is expressed in terms of the
difference between the pretax and after-tax cost
of debt.
To illustrate, if r is the interest rate on debt, and t is
the marginal tax rate, the after-tax cost of
borrowing (kd) can be written as follows:
After-Tax Cost of Debt (kd) = r(1 t)
 There are three predictions that can be made
about debt ratios across companies and across
time:
The debt ratios of entities facing higher tax rates
should be higher than the debt ratios of comparable
entities facing lower tax rates
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
Companies with large net operating losses carried
forward should get far less in tax benefits from debt
than firms without these net operating losses.
Debt Discipline
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 firms to borrow can be an antidote to the
complacency. The managers now have to ensure
that the investments earn a return atleast equal to
or more than the interest payments.
 Downside
Debt increases expected bankruptcy costs
Direct costs of bankruptcy Legal and administrative costs
and pv of delays in paying cash out
Indirect costs
- perception on the part of the customers that the firm is in
trouble
- stricter terms : suppliers start demanding to protect
themselves against the possibility of default, leading to an
increase in working capital and a decrease in cash flows,
the difficulty the firm may experience trying to raise fresh
capital for its projects
 Bankruptcy indirect costs are higher for the
following firms:
Firms that sell durable products with long lives that require
replacement parts and service
PC manufacturer vs. grocery store
Firms that provide goods or services for which quality is an
important attribute but is difficult to determine in advance
Kingfisher Airlines
Firms producing products whose value to customers depends
on the services and complementary products supplied by
independent companies
Apple Computers and Apps
Firms that sell products that require continuous service and
support from the manufacturer
Xerox Machines
 Implications for Optimal Capital Structure
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 provides protection against
bankruptcy, by providing either insurance or bailouts,
firms will tend to borrow more.
Because the direct bankruptcy costs are higher, when
the assets of the firm are not easily divisible and
marketable, firms with assets that can be easily divided
and sold should be able to borrow more than firms with
assets that do not share these features
Firms that produce products that require long-term servicing and
support generally should have lower leverage than firms whose
products do not share this feature
Debt Creates Agency Costs
a. 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 interest rates on debt.
b. 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, because 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.
Implications to optimal capital
structure
First, the agency cost arising from risk shifting is
likely to be greatest in firms whose investments
cannot be easily observed and monitored
Second, the agency cost associated with
monitoring management 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
 Excess debt causes loss of financial flexibility
When a firm borrows up to its capacity, it loses
the flexibility of financing future projects with debt
Summarizing Debt Equity Trade off
Example
A firm has following EBIT under three different
scenarios:

Economic Scenario EBIT

Recession 4 million
Moderate Growth 10 million
Economic Boom 18 million

Assume it has 10 million shares outstanding, no debt

and a tax rate of 40% and it faces two alternatives:
It will remain all equity firm
It can borrow 50 million at 10%, buyback half the O/S
shares and reduce the number of O/S shares to 5 million.
 Analysis of Leverage
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
0 2 4 6 8 10 12 14 16 18 20
-0.2
-0.4

EPS EPS
EBIT EPS Analysis
Presents riskiness of leverage intuitively by noting
that debt accentuates both the potential benefits
and losses for equity investors
Provides a measure of the breakeven between
two strategies
May not be the best way to think about leverage
due to
Predicted on current earnings
Does not differentiate firm specific and market
specific risks
Does not measure consequences on value of the
firm.
Optimal Capital Structure
Modigliani Miller Theorem
Whether there is an optimal capital structure??
Miller and Modigliani drew their conclusions in a
world void of taxes, transaction costs, and the
possibility of default
They concluded that the value of a firm was
unaffected by its leverage and that investment
and financing decisions could be separated
Does Debt Policy Matter?
Modigliani and Miller Theorem
If (i) a firms total after tax cash flows to security
holders are independent of how it is financed; (ii)
there were no transactions costs; and (iii) there are
no regulatory distortions, then the total market value
of the firm (debt and equity) is independent of how it
is financed
In a perfect market, any combination of securities
is as good as another
Value of the firm is unaffected by its choice of
capital structure
Proposition I
No Taxes
The value of levered firm is the same as the value
of unlevered firm
Proposition II
No Taxes
Risk to equity holders rises with leverage
Required return to equity holders rises with
leverage B
Rs Ro ( Ro Rb )
S
where :
Rs cos t of equity
Ro Cost of capital for all equity firm
Rb Cost of debt
B Value of debt
S Value of stock
An analogy Sell whole milk

By skimming he
can sell a
combination of
low fat milk and
A dairy farmer has 2 choices cream

Can get a high price Low price

The Irrelevance of Debt in a Tax-
Free World
Debt with no benefits and costs
 In a later study, Miller and Modigliani preserved this
environment but made one change, allowing for a tax
benefit for debt.
In this scenario, where debt continues to have no costs,
the optimal debt ratio for a firm is 100 percent debt.
In fact, in such an environment the value of the firm
increases by the present value of the tax savings for
interest payments.

Value of Levered Firm = Value of Unlevered Firm + tcB

where tc is the corporate tax rate and B is the dollar
borrowing.
Note that the second term in this valuation is the present value
of the interest tax savings from debt, treated as a perpetuity.
TAXES
Proposition I:
Vl=Vu+tcb
Proposition II:
B
Rs Ro (1 tc )( Ro Rb )
S
where :
Rs cos t of equity
Ro Cost of capital for all equity firm
Rb Cost of debt
B Value of debt
S Value of stock
 Miller and Modigliani presented an alternative
proof of the irrelevance of leverage, based on the
idea that debt does not affect the underlying
operating cash flows of the firm in the absence of
taxes.
Consider two firms that have the same cash flow
(X) from operations.
Firm A is an all-equity firm, whereas firm B has
both equity and debt. The interest rate on debt is
r. Assume you are an investor and you buy a
fraction of the equity in firm A, and the same
fraction of both the equity and debt of firm B.
The Irrelevance of debt with taxes
When taxes are introduced into the model, debt
does affect value
In fact, introducing both taxes and bankruptcy
costs into the model creates a trade-off, where
the financing mix of a firm affects value, and there
is an optimal mix
Miller argued that the debt irrelevance theorem
could apply even in the presence of corporate
taxes if taxes on the equity and interest income
individuals receive from firms were included in the
analysis
 To demonstrate the Miller proof of irrelevance,
assume that investors face a tax rate of td on
interest income and a tax rate of te on equity
income.
Assume also that the firm pays an interest rate of
r on debt and faces a corporate tax rate of tc.
The after-tax return to the investor from owning
debt can then be written as:
After-Tax Return from Owning Debt = r(1 td)
 The after-tax return to the investor from owning
equity can also be estimated.
Because cash flows to equity have to be paid out
of after-tax cash flows, equity income is taxed
twiceonce at the corporate level and once at
the equity level:
After-Tax Return from Owning Equity = ke(1 tc)(1
te)
 Miller noted that the tax benefit of debt, relative to equity
becomes smaller, because both debt and equity now get
taxed, at least at the level of the individual investor.

Tax Benefit of Debt, Relative to Equity = {1 (1 tc)(1

te)}/(1 td)

With this relative tax benefit, the value of the firm, with
leverage, can be written as:
VL = Vu + [1 (1 tc)(1 te)/(1 td)]B
Where,
VL is the value of the firm with leverage,
VU is the value of the firm without leverage,
B is the dollar debt.
 With this expanded equation, which includes both personal
and corporate taxes, there are several possible scenarios:
a. Personal tax rates on both equity and interest income
are zero:

If we ignore personal taxes, this equation compresses to the

original equation for the value of a levered firm, in a world with
taxes but no bankruptcy costs:
VL = Vu + tc B
b. The personal tax rate on equity is the same as the tax
rate on debt:
If this were the case, the result is the same as the original
onethe value of the firm increases with more debt.
VL = Vu + tc B
c. The tax rate on debt is higher than the tax rate on equity:
In such a case, the differences in the individual investor tax
rates may more than compensate for the double taxation
of equity cash flows.
Assume that the tax rate on ordinary income is 70 percent,
the tax rate on capital gains on stock is 28 percent, and the
tax rate on corporations is 35 percent.
In such a case, the tax liabilities for debt and equity can be
calculated for a firm that pays no dividend as follows:
Tax Rate on Debt Income = 70%
Tax Rate on Equity Income = 1 (1 0.35) (1 0.28) =
0.532 or 53.2%
d. The tax rate on equity income is just low enough
to compensate for the double taxation
In this case, we are back to the original debt
irrelevance theorem.
(1 td) = (1 tc)(1 te) . . . Debt is irrelevant
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )

1-Td
(1-Te) (1-Tc)

Advantage
RAF > 1 Debt
RAF < 1 Equity
C.S. & Taxes (Personal & Corp)
Operating Income (Rs.1.00)

Paid out as Or paid out as

interest equity income

Corporate Tax None Tc

Income after Rs.1.00 Rs.1.00 Tc

Corp Taxes

Personal Taxes Td Te (1.00-Tc)

.

Income after All Rs.1.00 Td Rs.1.00Tc-TE (1.00-

Taxes Tc) =(1.00-TE)(1.00-Tc)

To bondholders To stockholders
 C.S. & Taxes (Personal & Corp)
Example
Interest Equity Income
Income before tax Rs. 1 Rs. 1
Less corporate tax
at T c = 0.3366 0 0.34
Income after corporate tax 1 0.66
Personal tax at T p = 0.3366
and T pE = 0.02856 0.34 0.02
Income after all taxes Rs. 0.66 Rs. 0.64

Advantage to debt = Rs.0.02

 C.S. & Taxes (Personal & Corp)
Todays RAF & Debt vs Equity preference.

(1-.3366)
RAF = = 1.03
(1-.02866)(1-.3366)
Capital Structure and Firm Value
Net Income Approach

Rates of
Return

re
ra
rd

D/E
Capital Structure and Firm Value
Net Operating Income Approach (David Durand)

Rates of re
Return
ra

rd

D/E

Re=ra + (ra-rd)(D/E)
Debt Irrelevance (MM)

Rates of re
Return
ra

rd

D/E

Any benefits incurred by substituting cheaper debt for more expensive equity
are offset by increases in their costs
Debt Irrelevance (MM Prop. II)

Rates of re
Return
ra

rd

D/E
What MM made us think?
What do perfect markets mean?
Is value maximization always right objective?
Do PVs add up?
What does risk class mean?
What about default risk?
Taxes, information etc.
There is an optimal capital structure
The counter to the Miller-Modigliani proposition is that
the trade-offs on debt may work in favor of the firm (at
least initially) and that borrowing money may lower
the cost of capital and increase firm value
If the debt decision involves a trade-off between the
benefits of debt (tax benefits and added discipline)
and the costs of debt (bankruptcy costs, agency
costs, and lost flexibility), it can be argued that the
marginal benefits will be offset by the marginal costs
only in exceptional cases and not always then (as
argued by Miller and Modigliani)
 the marginal benefits will either exceed the
marginal costs (in which case debt is good and
will increase firm value) or
fall short of marginal costs (in which case equity
is better).

Accordingly, there is an optimal capital structure

for most firms at which firm value is maximized.
Rates of re
Return
ra

rd

D/E
Empirical Evidence (Bradley, Jarrell and Kim,
1984; Barclay, Smith and Watts, 1995)
Variable Impact on debt ratio

Marginal tax rate

Separation of ownership and

management

Variability in operating cash Flows

Debt holders difficulty in monitoring

firm
actions, investments, and
performance
Need for flexibility
How firms choose their capital
structure?
Three alternative views
Financing mix and life cycle
Debt ratios peak when firms are in mature growth phase
Financing mix as per comparable firms
Tend not to stray too far from their sector averages
Financing Hierarchy