STRATEGIC FINANCIAL MANAGEMENT The Trade off of Debt KHURAM RAZA ACMA, MS FINANCE First Principle and Big Picture The Trade off of Debt Why use debt instead of equity? The Benefits of Debt  Debt Has A Tax Advantage  Annual Tax Savings arising from the Interest Payment = t r B  Present Value of Tax Savings from Debt = t r B / r = t B  Value of Levered Firm with debt B = Value of Unlevered Firm + t B  After-tax Cost of Debt (k) = r (1 - t)d The Trade off of Debt Why use debt instead of equity? The Benefits of Debt  Debt make Managers more Disciplined  Borrowing creates the commitment to make interest and principal payments, increasing the risk of default on projects with sub-standard returns The Trade off of Debt Why use debt instead of equity? The Costs of Debt  Debt increases expected bankruptcy costs The Probability of Bankruptcy  Size of operating cash flows relative to size of cash flows on debt obligations  Variance in Operating Cash Flows The Cost of Bankruptcy  Direct Costs  Indirect Costs The Trade off of Debt Why use debt instead of equity? The Costs of Debt Debt creates agency costs  equity investors generally control the firm’s management and decision making, their interests will dominate bondholder interests unless bondholders take some protective action By borrowing money, a firm exposes itself to this conflict and its negative consequences and it pays the price in terms of both higher interest rates and a loss of freedom in decision making  The conflict between bondholder and stockholder interests appears in all three aspects of corporate finance  deciding what projects to take (making investment decisions),  choosing how to finance these projects and  determining how much to pay out as dividends: The Trade-off in a Balance Sheet Format Advantages of Borrowing Tax Benefit: Higher tax rates > Higher tax benefit Added Discipline: Greater the separation between managers and stockholders > Greater the benefit Disadvantages of Borrowing Bankruptcy Cost: Higher business risk > Higher Cost Agency Cost: Greater the separation between stockholders and lenders > Higher Cost Optimal Capital Mix We have just argued that debt has advantages, relative to equity, as well as disadvantages Will trading off the costs and benefits of debt yield an optimal mix of debt and equity for a firm?  Modigliani-Miller Theorem Miller and Modigliani drew their conclusions in a world void of taxes, transactions costs, and the possibility of default Based upon these assumptions, they concluded that the value of a firm was unaffected by its leverage Optimal Capital Mix Relevance of Tax Benefits Value of Levered Firm = Value of Unlevered Firm + t B Relevance of Bankruptcy Cost Higher Business Risk Higher Equity Return Higher Debt COst Arbitrage Arbitrage Investment Equity Debt Return Interest NL L 400 300 400 - 100 36 64 - How Firms Choose their Capital Structures Financing Mix and a Firm’s Life Cycle Financing Mix based on Comparable Firms Following A Financing Hierarchy  flexibility and control  Costs of issuance  Signaling impact ... equity? The Costs of Debt Debt creates agency costs  equity investors generally control the firm’s management and decision making, their interests will dominate bondholder interests unless bondholders