the trade off for disney, vale, tata motors and...
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TheTradeoffforDisney,Vale,TataMotorsandBaidu
Aswath Damodaran
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Debt trade off Discussion of relative benefits/costs Tax benefits Marginal tax rates of 40% in US (Disney & Bookscape), 32.5% in India (Tata
Motors), 25% in China (Baidu) and 34% in Brazil (Vale), but there is an offsetting tax benefit for equity in Brazil (interest on equity capital is deductible).
Added Discipline
The benefits should be highest at Disney, where there is a clear separation of ownership and management and smaller at the remaining firms.
Expected Bankruptcy Costs
Volatility in earnings: Higher at Baidu (young firm in technology), Tata Motors (cyclicality) and Vale (commodity prices) and lower at Disney (diversified across entertainment companies). Indirect bankruptcy costs likely to be highest at Tata Motors, since it’s products (automobiles) have long lives and require service and lower at Disney and Baidu.
Agency Costs Highest at Baidu, largely because it’s assets are intangible and it sells services and lowest at Vale (where investments are in mines, highly visible and easily monitored) and Tata Motors (tangible assets, family group backing). At Disney, the agency costs will vary across its business, higher in the movie and broadcasting businesses and lower at theme parks.
Flexibility needs
Baidu will value flexibility more than the other firms, because technology is a shifting and unpredictable business, where future investment needs are difficult to forecast. The flexibility needs should be lower at Disney and Tata Motors, since they are mature companies with well-established investment needs. At Vale, the need for investment funds may vary with commodity prices, since the firm grows by acquiring both reserves and smaller companies. At Bookscape, the difficulty of accessing external capital will make flexibility more necessary.
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6 ApplicationTest:Wouldyouexpectyourfirmtogainorlosefromusingalotofdebt?
Aswath Damodaran
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¨ Considering,foryourfirm,¤ Thepotentialtaxbenefitsofborrowing¤ Thebenefitsofusingdebtasadisciplinarymechanism¤ Thepotentialforexpectedbankruptcycosts¤ Thepotentialforagencycosts¤ Theneedforfinancialflexibility
¨ Wouldyouexpectyourfirmtohaveahighdebtratiooralowdebtratio?
¨ Doesthefirm’scurrentdebtratiomeetyourexpectations?
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AHypotheticalScenario
Aswath Damodaran
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Assumethatyouliveinaworldwhere(a)Therearenotaxes(b)Managershavestockholderinterestsatheartanddowhat’sbestforstockholders.(c)Nofirmevergoesbankrupt(d)Equityinvestorsarehonestwithlenders;thereisnosubterfugeorattempttofindloopholesinloanagreements.(e)Firmsknowtheirfuturefinancingneedswithcertainty
¨Whathappenstothetradeoffbetweendebtandequity?Howmuchshouldafirmborrow?
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TheMiller-ModiglianiTheorem
Aswath Damodaran
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¨ Inanenvironment,wheretherearenotaxes,defaultriskoragencycosts,capitalstructureisirrelevant.
¨ IftheMillerModiglianitheoremholds:¤ Afirm'svaluewillbedeterminedthequalityofitsinvestmentsandnot
byitsfinancingmix.¤ Thecostofcapitalofthefirmwillnotchangewithleverage.Asafirm
increasesitsleverage,thecostofequitywillincreasejustenoughtooffsetanygainstotheleverage.
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Whatdofirmslookatinfinancing?
Aswath Damodaran
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¨ Therearesomewhoarguethatfirmsfollowafinancinghierarchy,withretainedearningsbeingthemostpreferredchoiceforfinancing,followedbydebtandthatnewequityistheleastpreferredchoice.Inparticular,¤ Managersvalueflexibility.Managersvaluebeingabletousecapital(onnewinvestmentsorassets)withoutrestrictionsonthatuseorhavingtoexplainitsusetoothers.
¤ Managersvaluecontrol.Managerslikebeingabletomaintaincontroloftheirbusinesses.
¨ Withflexibilityandcontrolbeingkeyfactors:¤ Wouldyouratheruseinternalfinancing(retainedearnings)orexternalfinancing?
¤ Withexternalfinancing,wouldyouratherusedebtorequity?
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Preferencerankingslong-termfinance:Resultsofasurvey
Aswath Damodaran
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Ranking Source Score
1 Retained Earnings 5.61
2 Straight Debt 4.88
3 Convertible Debt 3.02
4 External Common Equity 2.42
5 Straight Preferred Stock 2.22
6 Convertible Preferred 1.72
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Andtheunsurprisingconsequences..
Aswath Damodaran
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0%
10%
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% o
f Fin
anci
ng fr
om D
iffer
ent
Sour
ces
Year
External and Internal Financing at US Firms
External Financing from Debt
External Financing from Common and Preferred Stock
Internal Financing
In
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FinancingChoices
Aswath Damodaran
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¨ YouarereadingtheWallStreetJournalandnoticeatombstoneadforacompany,offeringtosellconvertiblepreferredstock.Whatwouldyouhypothesizeaboutthehealthofthecompanyissuingthesesecurities?
a. Nothingb. Healthierthantheaveragefirmc. Inmuchmorefinancialtroublethantheaverage
firm
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CAPITALSTRUCTURE:FINDINGTHERIGHTFINANCINGMIX
Youcanhavetoomuchdebt…ortoolittle..
Aswath Damodaran 33
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TheBigPicture..
Aswath Damodaran
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PathwaystotheOptimal
Aswath Damodaran
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1. TheCostofCapitalApproach:Theoptimaldebtratioistheonethatminimizesthecostofcapitalforafirm.
2. TheEnhancedCostofCapitalapproach:Theoptimaldebtratioistheonethatgeneratesthebestcombinationof(low)costofcapitaland(high)operatingincome.
3. TheAdjustedPresentValueApproach:Theoptimaldebtratioistheonethatmaximizestheoverallvalueofthefirm.
4. TheSectorApproach:Theoptimaldebtratioistheonethatbringsthefirmclosestoitspeergroupintermsoffinancingmix.
5. TheLifeCycleApproach:Theoptimaldebtratioistheonethatbestsuitswherethefirmisinitslifecycle.
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I.TheCostofCapitalApproach
Aswath Damodaran
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¨ ValueofaFirm=PresentValueofCashFlowstotheFirm,discountedbackatthecostofcapital.
¨ Ifthecashflowstothefirmareheldconstant,andthecostofcapitalisminimized,thevalueofthefirmwillbemaximized.
¨ CostofCapital=CostofEquity(E/(D+E))+Pre-taxCostofDebt(1- t)(D/(D+E)¨ Thequestionthenbecomesasimpleone.Asthedebtratiochanges,howdoesthecostofcapitalchange?
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TheDebtTradeoffontheCostofCapital
Aswath Damodaran
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CostsofDebt&Equity
Aswath Damodaran
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¨ AnarticleinanAsianbusinessmagazinearguedthatequitywascheaperthandebt,becausedividendyieldsaremuchlowerthaninterestratesondebt.Doyouagreewiththisstatement?
a. Yesb. No¨ Canequityeverbecheaperthandebt?a. Yesb. No