CAPITAL’STRUCTURE:’ FINDING’THE’RIGHT’FINANCING’ MIX

Aswath Damodaran

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CAPITAL STRUCTURE: FINDING THE RIGHT FINANCING MIX

You can have too much debt... or too liEle..

The Big Picture..

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Maximize the value of the business (firm)

The Investment Decision Invest in assets that earn a

return greater than the minimum acceptable hurdle

rate

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

fund your operations

The Dividend Decision If 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

Aswath Damodaran

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Pathways to the OpNmal

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1. The Cost of Capital Approach: The opNmal debt raNo is the one that minimizes the cost of capital for a firm.

2. The Enhanced Cost of Capital approach: The opNmal debt raNo is the one that generates the best combinaNon of (low) cost of capital and (high) operaNng income.

3. The Adjusted Present Value Approach: The opNmal debt raNo is the one that maximizes the overall value of the firm.

4. The Sector Approach: The opNmal debt raNo is the one that brings the firm closes to its peer group in terms of financing mix.

5. The Life Cycle Approach: The opNmal debt raNo is the one that best suits where the firm is in its life cycle.

Aswath Damodaran

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I. The Cost of Capital Approach

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? Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.

? If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.

Aswath Damodaran

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Measuring Cost of Capital

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? Recapping our discussion of cost of capital: ? The cost of debt is the market interest rate that the firm has to pay on its

long term borrowing today, net of tax benefits. It will be a funcNon of:

(a) The long--term riskfree rate (b) The default spread for the company, reflecNng its credit risk (c) The firm's marginal tax rate

? The cost of equity reflects the expected return demanded by marginal equity investors. If they are diversified, only the porNon of the equity risk that cannot be diversified away (beta or betas) will be priced into the cost of equity.

? The cost of capital is the cost of each component weighted by its relaNve market value.

Cost of capital = Cost of equity (E/(D+E)) + Ader--tax cost of debt (D/(D+E))

Aswath Damodaran

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