In this chapter, we have laid the ground work for analyzing a firm's optimal mix of debt and equity by laying out the benefits and the costs of borrowing money. In particular, we made the following points:

• We differentiated between debt and equity, at a generic level, by pointing out that any financing approach that results in fixed cash flows and has prior claims in the case of default, fixed maturity, and no voting rights is debt, while a financing approach that provides for residual cash flows and has low or no priority in claims in the case of default, infinite life, and a lion's share of the control is equity.

• While all firms, private as well as public, use both debt and equity, the choices in terms of financing and the type of financing used change as a firm progresses through the life cycle, with equity dominating at the earlier stages and debt as the firm matures.

• The primary benefit of debt is a tax benefit: interest expenses are tax deductible and cash flows to equity (dividends) are not. This benefit increases with the tax rate of the entity taking on the debt. A secondary benefit of debt is that it forces managers to be more disciplined in their choice of projects by increasing the costs of failure; a series of bad projects may create the possibility of defaulting on interest and principal payments.

• The primary cost of borrowing is an increase in the expected bankruptcy cost — the product of the probability of default and the cost of bankruptcy. The probability of default is greater for firms that have volatile cash flows. The cost of bankruptcy includes both the direct costs (legal and time value) of bankruptcy and the indirect costs (lost sales, tighter credit and less access to capital). Borrowing money exposes the firm to the possibility of conflicts between stock and bond holders over investment, financing, and dividend decisions. The covenants that bondholders write into bond agreements to protect themselves against expropriation cost the firm in both monitoring costs and lost flexibility. The loss of financial flexibility that arises from borrowing money is more likely to be a problem for firms with substantial and unpredictable investment opportunities.

• In the special case where there are no tax benefits, default risk, or agency problems, the financing decision is irrelevant. This is known as the Miller-Modigliani theorem. In most cases, however, the trade-off between the benefits and costs of debt will result in an optimal capital structure, whereby the value of the firm is maximized.

• Firms generally choose their financing mix in one of three ways - based upon where they are in the life cycle, by looking at comparable firms or by following a financing hierarchy where retained earnings is the most preferred option and convertible preferred stock the least.

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