CAPITAL’STRUCTURE:’ FINDING’THE’RIGHT’FINANCING’ MIX
Aswath Damodaran
1
CAPITAL
STRUCTURE:
FINDING
THE
RIGHT
FINANCING
MIX
You
can
have
too
much
debt...
or
too
liEle..
The
Big
Picture..
2
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
2
Pathways
to
the
OpNmal
3
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
3
I.
The
Cost
of
Capital
Approach
4
? 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
4
Measuring
Cost
of
Capital
5
? 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
5
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