Financing Decisions and
The Cost of Capital
Where do Firms Get Their
Self Financing (using internal cash flow)
– Accounts for 80% (avg.) of financing
– Difficult for start-up companies
– Borrowing from banks or issuing bonds
– Sharing the business with investors by issuing
The Long-Term Financial Deficit
Uses of Cash Flow Sources of Cash Flow
Capital Internal cash
spending flow (retained
80% earnings plus Internal
depreciation) cash flow
capital plus Long-term External
other uses debt and cash flow
20% equity 30%
Where Do Small Businesses
0 10 20 30 40 50 60
Fraction of Funds Raised (%)
Source: 1987 SBA survey of firms with less than $500,000 in assets.
What Happens As Firms Get
Very small, no track record Small with growth potential Medium-sized Large with Track record
Inside seed money
Short Debt Short-term commercial loans Commercial paper
Intermediate-term commercial loans Medium-term
Debt Mezzanine Finance Private Placements
Outside Equity Venture Capital Public Equity
Source: FRB Report on Private Placements, Rea et. al., 1993
What is the Difference
Between Debt and Equity?
Fixed Promised Uncertain residual
payments cash flows
Senior to equity Subordinated
Interest is deductible Dividends are not
Only get control deductible
rights in default Comes with control
rights (can vote)
Recent Trends in Financing
This important question is difficult to answer
Book or Market values?
– In general, financial economists prefer market
values. Debt levels have fallen recently.
– However, many corporate treasurers find book
values more appealing due to the volatility of
market values. These have slightly risen recently.
Whether we use book or market values, debt
ratios for U.S. non-financial firms have
remained below 60 percent of total financing.
How should a firm structure the
liability side of the balance sheet?
Debt vs. Equity
We have seen how to do capital budgeting
when the firm has debt in its capital structure.
However, we have not figured out how much
debt the firm should have.
– Can the firm create value for shareholders
through its financing decisions?
In particular, should the firm load up with „low
One possible answer:
It makes no difference.
Assume PCM, importantly, there are no taxes, and that the
firm‟s investment policy is unaffected by how it finances its
Both Modigliani and Miller won the Nobel Prize for showing:
The value of a firm with debt is in this case equal to the
value of the same firm without debt. MM Proposition I.
The important idea is that since the assets are the same
regardless of how they are financed so are the expected
cash flows and so are the asset risks (asset betas) of a
“levered” and “unlevered” firm.
Irrelevance Proposition II
What this means is that the expected return
on equity rises with leverage according to:
(B/S = leverage ratio -- market value of debt
over market value of equity, r denotes
rEquity rAssets (rAssets rDebt )
WACC under Irrelevance
Let the expected return on the underlying assets be 9% and the
cost of debt be 6%.
B/S M = B/(B+S) Equity WACC
0.00 0.00 9.00 9.00
0.50 0.33 10.50 9.00
1.00 0.50 12.00 9.00
1.50 0.60 13.50 9.00
2.00 0.67 15.00 9.00
3.00 0.75 18.00 9.00
MM Proposition II with No Corporate
Taxes: Another View
Cost of capital: r (%)
rS r0 (r0 rB )
r0 rW ACC rB rS
Debt-to-equity Ratio B
What About The Tax
Deductibility of Interest?
Interest is tax deductible (dividends are not).
A valuable “debt tax shield” is created by substituting
payments of interest for payments of dividends, i.e.
debt financing for equity financing.
Modigliani and Miller also showed that if the only
change in their analysis is an acknowledgement of
the US corporate tax structure, then:
The value of a levered firm is: VL = VU + TcB
– the value of an equivalent unlevered firm PLUS
– the value of the tax shields from debt.
Firm Value always rises with additional borrowing!
Proposition II with Taxes
When we take the tax deductibility of
interest payments into account the
equations we presented must change:
rWACC rS rB (1 Tc )
rS rA (1 Tc )(rA rB )
Cost of capital: r
rS r0 (1 TC ) (r0 rB )
rW ACC rB (1 TC ) rS
BSL B SL
Limits to The Use of Debt
Given the treatment the U. S. corporate tax code
gives to interest payments versus dividend
payments, firms have a big incentive to use debt
Under the MM assumptions with corporate taxes
the argument goes to extremes and the message
becomes: firms should use 100% debt financing.
What other costs are associated with the use of
– Bankruptcy costs and/or financial distress
– Legal fees
– Accounting fees
– Costs associated with a trial (expert witnesses)
– Reduced effectiveness in the market.
– Lower value of service contracts, warranties.
Decreased willingness of suppliers to provide
– Loss of value of intangible assets--e.g., patents.
Agency costs of debt
When bankruptcy is possible incentives may be
Example (Risk Shifting):
– Big Trouble Corp. (BTC) owes its creditors $5 million, due in
– BTC has liquidated its assets because it could not operate
profitably. Its remaining asset is $1 million cash.
– Big Bill, the lone shareholder and general manager is
considering two possible investments.
(1) Buy six month T-bills to earn 3% interest.
(2) Go to Vegas and wager the entire $1 million on a
single spin of the roulette wheel.
– Why might Bill consider the second “investment”?
– Would he have considered it in the absence of leverage?
– Slight Trouble Corp. (STC) has a small but significant
chance of bankruptcy in the next few years. Its debt is
trading far below par.
– Managers are evaluating an investment project that will cost
$1 million to undertake. The alternative is to pay $1 million
out as dividends.
– While the NPV of the project is positive it may be that the
shareholders are better off with the dividend than if the
project is taken.
– The reason is that while shareholders pay all the costs of the
project, they will have to share the value with bondholders,
the added value will raise bond prices as well as stock
Disciplinary Power of Debt
“On the other hand” as economists are fond
of saying, debt can be a disciplinary device.
– It has long been realized that an owner works
harder and makes better decisions than does an
– This was an often cited justification for the LBO
wave of the mid 80‟s and early 90‟s.
Idea is that one of the most contentious
issues between managers and shareholders
is the payout of excess cash.
– Debt allows manager to commit to the payout in a
way that cannot be accomplished with a dividend
A Theory of Capital Structure
Thevalue of a levered firm can be thought of as:
the value of an equivalent but unlevered firm
+ present value of tax shields (net)
– present value of expected bankruptcy costs and
The Value of the Firm with Costs
of Financial Distress
Value of firm (V)
VL = VU +TC B = Value of firm under
Present value of tax
shield on debt MM with corporate
Maximum taxes and debt
firm value Present value of financial distress costs
V= Actual value of firm
VU= Value of firm with no debt
Optimal amount of debt
The tax shield increases the value of the levered firm. Financial distress
costs lower the value of the levered firm. The two offsetting factors produce
an optimal amount of debt.
Pecking Order Theory says that there is no
optimal capital structure, just the culmination
of all your financing decisions.
– Internally generated funds.
– External Debt.
– External Equity as a last resort.
Data shows that preferences such as these
are there but a subject of debate is whether
they are necessarily inconsistent with there
being an optimal capital structure.
Choosing an Amount of Debt
The theory provides no clear formula (unlike NPV)
but the tradeoffs are clear; the benefits versus the
costs of debt.
Use more debt if:
– effective tax rates (without debt) are higher,
– operating cash flows are more predictable,
– agency costs can be controlled by contracts.
A safe strategy might be to emulate the industry average.
After all these are the firms who have survived. From there
you make alterations as your own situation dictates.
Ralph‟s firm has been in the food processing
business for the last 10 years. It has
maintained a conservative capital structure
financing 60% of its value with equity.
Ralph has recently considered investing in
the IPO of a start-up company that will
develop and manufacture internet
infrastructure. In discussions with the start-
up‟s manager, Ralph‟s nephew, it is revealed
that the start-up will use either no or 20%
debt financing. You have been called in to
help identify an appropriate cost of capital for
evaluating this investment.
Currently Ralph‟s equity beta is estimated at
0.95. There is no beta we can estimate for
this private company (the start-up) but we
know that Cisco has an equity beta of 1.92.
The risk free rate is 6% and the market risk
premium is 7%. The tax rate for all
corporations is 35%.
How can we approach determining the
appropriate discount rate?
Ralph’s Dilemma cont…
Start with the following:
S (1 T ) B Equity
We can reasonably assume that the asset
beta for Cisco will be a close estimate for the
asset beta for the start-up.
We know that the equity beta for Cisco is
1.92. What is Cisco‟s asset beta?
Ralph’s Dilemma cont…
Now we know that the asset beta for the start-up can
be estimated at 1.92. What is the equity beta?
We have two scenarios to consider, a debt to value
ratio of either 0% or 20%.
If it is zero, the equity beta equals the asset beta or
If it is 20%, we need to use:
B(1 TC ) .2(1 .35 )
Equity Assets 1 1.92 1 2.23
Ralph’s Dilemma cont…
Now we need a weighted average cost of
For the case of no debt rE = rA = rWACC:
– rE = 6% + 1.92(7%) = 19.44%.
With 20% debt:
– rE = 6% + 2.23(7%) = 21.61.
– rD = 6% (since we assumed the debt was riskless).
– rWACC = 21.61%(.8) + 6%(1-.35)(.2) = 18.07%.
– Why was I sure that I did something wrong when I
calculated the rWACC as 22.50% on my first try?
Example: BK Industries
If you recall, BK was evaluating a project in a very different
industry from its own with the following incremental cash
flows (FCF). At 10% we found an NPV of $5.2 million.
($ Millions) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
2000 2001 2002 2003 2004 2005
(A) Cash Flow -26.0 0.0 -0.632 -0.865 0.375 19.298
(B) Cash Flow 0.0 3.98 6.051 7.550 5.615 3.167
Project Cash -26.00 3.98 5.42 6.69 5.99 22.46
Flow [(A) + (B)]
Example: BK Industries Revisited
BK Industries is a conglomerate company
with operations in marine power, pleasure
boating, defense, and fishing tackle. BK‟s
equity beta is 1.0. BK has and will maintain a
debt/equity ratio of 1.0.
– Can we use the company cost of capital to
value the text editing project?
Latec Inc. is a firm that makes only text
editing systems. Latec‟s equity beta is 1.35.
Latec has a debt to equity ratio of 0.75, and a
marginal tax rate of 45%.
Delevered Betas with debt/equity
The formulas for obtaining asset betas from
equity betas and vice versa provided earlier
required dollars values for debt (B) and equity
(S). What if you are only given the leverage
ratio, L = B/S? The formulas are restated as:
1 L(1 TC )
Equity Assets (1 L(1 TC ))
Unlever Latec’s Beta to
obtain the Beta of Text-
Latec has L =0.75, TC = .45, and an equity
beta of 1.35.
Assets 1.35 0.955
1 0.75(1 0.45)
Relever the asset Beta to
reflect BK’s capital structure:
Recalling that BK will keep its debt/equity
ratio equal to one, we can get:
Equity 0.9551 1(1 .45) 1.48
•This is the beta for a BK equity position in a text
•Why is this equity beta greater than Latec’s?
BK Industries, Cont.
Assume that the risk free rate is 8% and that
BK‟s cost of debt is also 8%. The market risk
premium is 7%. Then the required return on
BK‟s equity is:
requity RF ( E[ RM ] RF ) 8% 1.48 * 7% 18.36%
The weighted average cost of capital for the text
editing venture (using the fact that B/S = 1) is:
WACC rS rB (1 TC )
= 18.36% 8%(1 0.45) 11.38%
Finally,we can evaluate the NPV of the text
editing venture using the WACC that reflects the
risk associated with this particular business.
Using the cash flow estimates obtained earlier:
3.980 5.419 6.685 5.990 22.465
(1.1138) (1.1138) 2 (1.1138)3 (1.1138) 4 (1.1138)5
• The NPV is positive, so proceed with the text editing business.
• Note also that the market value of the project will be $28.78 M.
• Notice that the selected discount rate of 11.38% reflects:
The risk (beta) of text editing businesses, not BK’s existing
BK’s capital structure, not that of the comparable firm.
BK Industries‟ debt to equity ratio is 1.0
as it is for the project. BK‟s equity beta
prior to starting the text editing business
was 1.0 (levered beta).
– What will happen to the beta of BK Industries after
starting the text editing business?
– Suppose that BK uses its firm cost of capital to
evaluate the text business? Would this favor the
– Does BK diversifying into the text editor business
help shareholders by providing them a more
An Alternative Approach
The Adjusted Present Value (APV):
– Follows from the MM equation
VL = VU + TCB.
– Take the value of the project, if it were unlevered,
then add the debt tax shields (more completely the
additional effects of debt).
– Let‟s just do the exercise. We have cash flows for
the unlevered firm but remember that the formulas
are derived using a perpetuity (a simplification).
– If BK‟s project generates $3.39124 million each
year forever its NPV is the same using the WACC.
An Alternative Approach
The unlevered NPV is now, using the perpetual
equivalent cash flow derived as follows:
– rA = 8% + .955(7%) = 14.69%
– NPVU = $3.39124/.1469 – $26 = - $2.9 m
– APV = NPVU + TCB = -$2.9 + .45($14.9m)
= +$3.79 m.
This approach is most useful when you know the
dollar amount of debt that will be used each year
rather than the debt ratio over the life of the project
(perhaps an LBO or other highly levered