the financing decisionpeople.stern.nyu.edu/adamodar/pdfiles/country/capstrshort.pdf · 10 operating...

THEFINANCINGDECISION

Youcanhavetoomuchdebt…ortoolittle..

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DebtRatiosacrossCompanies

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DebtRatiosacrossSectors

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TheFinancialBalanceSheet

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Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments

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TheBigPicture..

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The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should reflect the magnitude and the timing of the

cashflows as welll as all side effects.

The optimal mix of debt and equity

maximizes firm value

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend on whether they

prefer dividends or buybacks

Maximize the value of the business (firm)

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Disney’sDebtLoad

¨ Attheendof2013,Disneyhad$15.96billionindebtoutstanding.¤ $13billioninconventionalinterestbearingdebt(withabookvalueof$14.3billion

¤ $2.96billioninoperatingleasedebt(withnodebtequivalentshownonthebalancesheet)

¨ Asapercentofitsmarketvalueasacompany,debtwas11.4%ofitsvalue.Asapercentofbookvalue,debtwas40%ofvalue.

¨ AsamultipleofEBITDA,debtwas1.3timesEBITDA.

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Tesla:DebtLoadovertime

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1.Definedebtbroadly

¨ GeneralRule:Debtgenerallyhasthefollowingcharacteristics:¤ Commitmenttomakefixedpaymentsinthefuture¤ Thefixedpaymentsaretaxdeductible¤ Failuretomakethepaymentscanleadtoeitherdefaultorlossofcontrolofthefirmtothepartytowhompaymentsaredue.

¨ Asaconsequence,debtshouldinclude¤ Anyinterest-bearingliability,whethershorttermorlongterm.

¤ Anyleaseobligation,whetheroperatingorcapital.

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OperatingLeasesatDisney

¨ The“debtvalue” ofoperatingleasesisthepresentvalueoftheleasepayments,ataratethatreflectstheirrisk,usuallythepre-taxcostofdebt.

¨ Thepre-taxcostofdebtatDisneyis3.75%.

¨ DebtoutstandingatDisney=$13,028+$2,933=$15,961million

Disney reported $1,784 million in commitments after year 5. Given that their average commitment over the first 5 years, we assumed 5 years @ $356.8 million each.

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Year Commitment Present Value @3.75% 1 $507.00 $488.67 2 $422.00 $392.05 3 $342.00 $306.24 4 $272.00 $234.76 5 $217.00 $180.52

6-10 $356.80 $1,330.69 Debt value of leases $2,932.93

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2.Thedebtdecisionisdrivenbyarealtradeoff

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Implication1:TheMarginalTaxRatematters

¨ Thetaxbenefitofdebtisdirectlylinkedtonotonlywhetheryouareallowedtodeductinterestexpensesfortaxpurposes,butalsoyourmarginaltaxrateonincome.¤ Ifinteresttaxdeductionsarelimited,companieswillborrowlessmoney.

¤ Asthemarginaltaxraterises(falls),companieswillborrowmore(less)money.

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Implication2:ExpectedBankruptcyCostsmatter

¨ Companieswillborrowlessmoney,ifexpectedbankruptcycostsrise.

¨ Expectedbankruptcycostsareafunctionof¤ Volatilityinearnings:Asearningsbecomelesspredicable,borrowingswillincrease

¤ Bankruptcylaws:Asbankruptcylawsbecomemore(less)lenient,companieswillborrowmore(less)

¨ Ifthegovernmentoperatesasabankrupt,bailingoutentitiesthatborrowtoomuch,everyentitywillborrowmore.

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Implication3:Thewiderthechasmbetweenlenders&equityinvestors..

¨ Agencycostsarisebecausewhatequityinvestorswantfromabusinessisverydifferentfromwhatlenderswantfromthebusiness.

¨ Whenlendingmoney,sensiblelendersincorporatethisrealityintowhethertheylend,howmuchtheylend,theinterestratestheychargeandthecovenantsthattheywriteintoloans.

¨ Themoredifficultitistomonitorwhatborrowersaredoingwiththelentmoney,thegreatertheagencycostsandthelesslendingtherewillbe.

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TheTradeoffforDisney

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¨ TaxBenefits:TheUShasthehighestmarginaltaxrateintheworld.Disney,sinceitmakesmoney,shouldbenefitfromusingdebt.

¨ AddedDiscipline:ThereisaseparationofownershipandmanagementatDisney,shouldleadtomoredebt.

¨ ExpectedBankruptcycosts:Disneyislargeandspreadovermultipleentertainmentbusinesses,withacashcowinESPN.Shouldleadtomoredebt.

¨ AgencyCosts:Disneyhasassetsthatarephysicalandtangible(themeparks)againstwhichitshouldbeabletoborrowmoney.

Bottomline:Disneyshouldborrowasubstantialamount.

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TheDebtTradeoffforTesla

¨ Notaxbenefits:Itisacompanythatis notonlystilllosingmoneybuthascarriedforwardlossesofcloseto$4.3billion,effectivelynullifyinganytaxbenefitsfromdebtforthenearfuture.

¨ Nodisciplinaryfunction:WithElonMusk,thelargeststockholderatthecompany,atthehelm,thereis nobasisfortheargumentthatdebtwillmakemanagersmoredisciplinedintheirinvestmentdecisions.

¨ Largebankruptcyrisk:Thecompanyisstillyoungandlosingmoney,and addingacontractualcommitmenttomakeinterestpaymentsontopofalloftheothercapitalneedsthatthecompanyhas,strikesmeasimprudent,withthepossibilitythatonebadyearcoulditspromiseatrisk.

¨ Agencyproblems:InacompanylikeTesla,makinglargeandriskybetsinnewbusinesses, thechasmbetweenlendersandequityinvestorsiswide,andlenderswilleitherimposerestrictionsonthecompanyorpriceintheirfears(ashigherinterestrates).

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3.Butmanydebtchoicesaredrivenbyillusorytradeoffs

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Orbyothermotives..

¨ Lackofaccesstoequity:Insomecases,companieshavetoborrowmoneybecausetheycannotraiseequity,eitherbecausetheyareprivatebusinessesorbecauseequitymarketsareundeveloped.

¨ Control:Inothercases,companiesthatshouldbeusingequityusedebtinsteadbecausethecompanyiscloselyheldandthecontrollingequityinterestsdon’twanttoriskgivingupcontrol.

¨ Subsidies:Sometimes,lenderslendat”subsidized”ratesandequityinvestorstakeadvantageofthosesubsidies.

WhichonedoyouthinkbestexplainsTesla?

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4.Themixofdebtandequitydrivesyourcostofcapital,andhenceyourvalue

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Andchangingthatmixwillchangeyourcostofcapital

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Hereisanexample:Disneyin2013

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Herearethe“firmspecific”determinants

¨ Marginaltaxrate:Holdingallelseconstant,loweringthetaxratewilllowertheoptimal.Atazeropercenttaxrate,Disney’soptimaldebtratiobecomeszero.

¨ CashFlowGeneration:Holdingallelseconstant,themorecashflowthatafirmgenerates,relativetoitsenterprisevalue,themoreitcanborrow.Disney’sEBITDAwas9.35%ofitsenterprisevaluein2013.

¨ VolatilityinCashflows:Holdingallelseconstant,themorevolatilecashflowsare,thelessacompanyshouldborrow.

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Andhereistheonlymacrodeterminant:Therelativepricesofriskinequity&debtmarkets

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ERP/Baa Spread Baa - T.Bond Rate ERP

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5.Andthepathwaytoyouroptimaldebtratiodependson..

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > OptimalOverlevered

Actual < OptimalUnderlevered

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withdebt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

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AppliedtoDisney(in2013)

Is the actual debt ratio greater than or lesser than the optimal debt ratio?

Actual > OptimalOverlevered

Actual < OptimalActual (11.58%) < Optimal (40%)

Is the firm under bankruptcy threat? Is the firm a takeover target?

Yes No

Reduce Debt quickly1. Equity for Debt swap2. Sell Assets; use cashto pay off debt3. Renegotiate with lenders

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

YesTake good projects withnew equity or with retainedearnings.

No1. Pay off debt with retainedearnings.2. Reduce or eliminate dividends.3. Issue new equity and pay off debt.

Yes No. Large mkt cap & positive Jensen’s a

Does the firm have good projects?ROE > Cost of EquityROC > Cost of Capital

Yes. ROC > Cost of capitalTake good projectsWith debt.

No

Do your stockholders likedividends?

YesPay Dividends No

Buy back stock

Increase leveragequickly1. Debt/Equity swaps2. Borrow money&buy shares.

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6.Therightdebtforyourfirmwilllooklikeequity

¨ Theobjectiveindesigningdebtistomakethecashflowsondebtmatchupascloselyaspossiblewiththecashflowsthatthefirmmakesonitsassets.

¨ Bydoingso,wereduceourriskofdefault,increasedebtcapacityandincreasefirmvalue.

Firm Value

Value of Debt

Firm Value

Value of Debt

Unmatched DebtMatched Debt

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DesigningDebt:Bringingitalltogether

Duration Currency Effect of InflationUncertainty about Future

Growth Patterns Cyclicality &Other Effects

Define DebtCharacteristicsDuration/Maturity

CurrencyMix

Fixed vs. Floating Rate* More floating rate - if CF move with inflation- with greater uncertainty on future

Straight versusConvertible- Convertible ifcash flows low now but highexp. growth

Special Featureson Debt- Options to make cash flows on debt match cash flows on assets

Start with the Cash Flowson Assets/Projects

Overlay taxpreferencesDeductibility of cash flowsfor tax purposes

Differences in tax ratesacross different locales

Consider ratings agency& analyst concernsAnalyst Concerns- Effect on EPS- Value relative to comparables

Ratings Agency- Effect on Ratios- Ratios relative to comparables

Regulatory Concerns- Measures used

Factor in agencyconflicts between stockand bond holders

Observability of Cash Flowsby Lenders- Less observable cash flows lead to more conflicts

Type of Assets financed- Tangible and liquid assets create less agency problems

Existing Debt covenants- Restrictions on Financing

Consider Information Asymmetries Uncertainty about Future Cashflows- When there is more uncertainty, itmay be better to use short term debt

Credibility & Quality of the Firm- Firms with credibility problemswill issue more short term debt

If agency problems are substantial, consider issuing convertible bonds

Can securities be designed that can make these different entities happy?

If tax advantages are large enough, you might override results of previous step

Zero Coupons

Operating LeasesMIPsSurplus Notes

ConvertibilesPuttable BondsRating Sensitive

NotesLYONs

Commodity BondsCatastrophe Notes

Design debt to have cash flows that match up to cash flows on the assets financed

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AppliedtoDisney

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Business Project Cash Flow Characteristics Type of Financing

Studio

entertainment

Movie projects are likely to • Be short-term • Have cash outflows primarily in dollars (because Disney makes most of its

movies in the U.S.), but cash inflows could have a substantial foreign currency component (because of overseas revenues)

• Have net cash flows that are heavily driven by whether the movie is a hit, which is often difficult to predict

Debt should be 1. Short-term 2. Mixed currency debt,

reflecting audience make-up.

3. If possible, tied to the success of movies.

Media networks Projects are likely to be 1. Short-term 2. Primarily in dollars, though foreign component is growing, especially for ESPN. 3. Driven by advertising revenues and show success (Nielsen ratings)

Debt should be 1. Short-term 2. Primarily dollar debt 3. If possible, linked to

network ratings Park resorts Projects are likely to be

1. Very long-term 2. Currency will be a function of the region (rather than country) where park is

located. 3. Affected by success of studio entertainment and media networks divisions

Debt should be 1. Long-term 2. Mix of currencies, based

on tourist makeup at the park.

Consumer products

Projects are likely to be short- to medium-term and linked to the success of the movie division; most of Disney’s product offerings and licensing revenues are derived from their movie productions

Debt should be 1. Medium-term 2. Dollar debt

Interactive Projects are likely to be short-term, with high growth potential and significant risk. While cash flows will initially be primarily in US dollars, the mix of currencies will shift as the business ages.

Debt should be short-term, convertible US dollar debt.