THE DEBT/EQUITY TRADEOFF
Aswath Damodaran
The trade off on debt versus equity
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The trade off at “your” firm

Considering, for your firm,
The potential tax benefits of borrowing
 The benefits of using debt as a disciplinary mechanism
 The potential for expected bankruptcy costs
 The potential for agency costs
 The need for financial flexibility



Would you expect your firm to have a high debt ratio
or a low debt ratio?
Does the firm’s current debt ratio meet your
expectations?
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Let’s start with potential tax benefits


Marginal tax rate: Start with the marginal tax rate of
the country in which the company is domiciled. If, as
is common, the company gets the largest share of its
income from the domestic market, the higher the
marginal tax rate, the more debt you should have.
Effective tax rate: While it is true that debt saves you
taxes at the margin, it is also true that the lower the
effective tax rate, the more likely it is that the
company has already found other ways to shelter
itself from taxes and needs debt less.
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Marginal tax rates
In 2012
Bahamas
Bermuda
Bonaire
Cayman Islands
Georgia
Guernsey
Isle of Man
Jersey
Canada
USA
N. America
Argentina
Bolivia
Brazil
Chile
Colombia
Costa Rica
Ecuador
El Salvador
Guatemala
Honduras
Mexico
Panama
Paraguay
Peru
Uruguay
Venezuela
Latin America
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0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
0.00%
26%
40%
33%
35%
25%
34%
18.5%
33%
30%
23%
30%
31%
35%
30%
25%
10%
30%
25%
34%
28.3%
Belgium
Germany
Portugal
Italy
Luxembourg
Austria
Denmark
France
33.99%
29.48%
25%
31.4%
28.8%
25%
25%
33.3%
Finland
24.5%
Greece
Iceland
20%
20%
Ireland
12.5%
Netherlands
Norway
Slovenia
Spain
Sweden
Switzerland
Turkey
UK
W.Europe
Angola
Botswana
Egypt
Kenya
Mauritius
Namibia
Nigeria
South Africa
Tunisia
Zambia
Africa
25%
28%
18%
30%
26.3%
21.2%
20%
24%
22.6%
35%
22%
25%
30%
15%
34%
30%
34.6%
30%
35%
29%
Albania
Armenia
Belarus
Bosnia &
Herzegovina
Bulgaria
Croatia
Czech Republic
Estonia
Georgia
Hungary
Kazakhstan
Latvia
Lithuania
Montenegro
Poland
Romania
Russia
Slovakia
Slovenia
Ukraine
E. Europe &
Russia
Bahrain
Israel
Jordan
Kuwait
Libya
Oman
Qatar
Saudi Arabia
Middle East
10%
20%
18%
10%
10%
20%
19%
21%
0%
19%
20%
15%
15%
9%
19%
16%
20%
19%
18%
21%
Bangladesh
Cambodia
China
Fiji Islands
Hong Kong
India
Indonesia
Japan
Korea
Malaysia
Pakistan
Papua New Guinea
Philippines
Singapore
Sri Lanka
Taiwan
Thailand
Vietnam
Asia
27.5%
20%
25%
28%
16.5%
32.5%
25%
38%
24.2%
25%
35%
30%
30%
17%
28%
17%
23%
25%
22.9%
Australia
New Zealand
Australia &
NZ
30%
28%
20.5%
0%
25%
14%
15%
20%
12%
10%
20%
14%
29%
Black #: Total ERP
Red #: Country risk premium
AVG: GDP weighted average
Effective tax rates across sectors: US in 2013
Industry name
Advertising
Aerospace/Defense
Air Transport
Apparel
Auto Parts
Automotive
Bank
Bank (Midwest)
Beverage
Biotechnology
Building Materials
Cable TV
Chemical (Basic)
Chemical (Diversified)
Chemical (Specialty)
Coal
Computer Software
Computers/Peripherals
Diversified Co.
Drug
E-Commerce
Educational Services
Electric Util. (Central)
Electric Utility (East)
Electric Utility (West)
Tax rate
32.82%
30.74%
31.82%
33.28%
30.29%
17.11%
24.92%
24.78%
32.52%
20.48%
26.15%
37.23%
25.68%
26.32%
26.64%
17.27%
25.35%
23.26%
28.09%
18.67%
27.19%
32.70%
32.00%
33.57%
30.05%
Industry name
Electrical Equipment
Electronics
Engineering & Const
Entertainment
Entertainment Tech
Environmental
Financial Svcs. (Div.)
Food Processing
Foreign Electronics
Funeral Services
Furn/Home Furnishings
Healthcare Information
Heavy Truck & Equip
Homebuilding
Hotel/Gaming
Household Products
Human Resources
Industrial Services
Information Services
Insurance (Life)
Insurance (Prop/Cas.)
Internet
Investment Companies
IT Services
Machinery
Tax rate
25.00%
22.26%
38.23%
27.43%
20.67%
26.91%
31.17%
32.51%
37.69%
32.15%
25.84%
38.51%
23.97%
35.07%
31.30%
30.67%
37.10%
37.37%
27.31%
28.84%
20.89%
29.30%
20.06%
23.93%
28.47%
Industry name
Machinery
Maritime
Med Supp Invasive
Med Supp Non-Invasive
Medical Services
Metal Fabricating
Metals & Mining (Div.)
Natural Gas (Div.)
Natural Gas Utility
Newspaper
Office Equip/Supplies
Oil/Gas Distribution
Oilfield Svcs/Equip.
Packaging & Container
Paper/Forest Products
Petroleum (Integrated)
Petroleum (Producing)
Pharmacy Services
Pipeline MLPs
Power
Precious Metals
Precision Instrument
Property Management
Public/Private Equity
Publishing
Tax rate
28.47%
17.65%
29.81%
27.13%
34.76%
34.47%
32.14%
28.85%
36.69%
27.30%
31.59%
25.78%
25.81%
27.51%
17.71%
35.29%
24.60%
31.87%
11.79%
33.64%
30.29%
24.56%
34.40%
23.29%
39.57%
Industry name
R.E.I.T.
Railroad
Recreation
Reinsurance
Restaurant
Retail (Hardlines)
Retail (Softlines)
Retail Automotive
Retail Building Supply
Retail Store
Retail/Wholesale Food
Securities Brokerage
Semiconductor
Semiconductor Equip
Shoe
Steel
Telecom. Equipment
Telecom. Services
Telecom. Utility
Thrift
Tobacco
Toiletries/Cosmetics
Trucking
Water Utility
Wireless Networking
Total Market
Tax rate
6.75%
31.78%
30.40%
14.88%
27.82%
32.79%
34.66%
34.57%
39.97%
35.25%
34.37%
44.89%
21.72%
15.91%
31.23%
33.30%
28.32%
30.64%
38.10%
27.52%
37.16%
31.90%
36.73%
34.63%
28.11%
28.37%
Added Discipline




Past Project Choice: Companies that have generated
poor returns on their investments in the past,
measured using return on capital and/or return on
equity are better candidates.
Past stock price performance: Companies whose
stocks have under performed the market (Jensen’s
alpha) are better candidates.
Insider holdings: Companies where the top
managers hold less stock are better candidates.
Activist presence: If an activist or activists are among
the top holders, there is less need for debt.
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Expected Bankruptcy Cost
I. The Probability of Bankruptcy

Quantitative measures




Level of operating earnings: Companies with higher cashflow available
to service debt should be able to borrow more.
Variance in earnings: Companies that operate in businesses where
earnings are more volatile face a higher probability of bankruptcy.
Dependence on one or a few customers: A firm that is dependent on
one or a few customers is more exposed.
Qualitative measures



Possibility of “catastrophic” risk: If there is a possibility of a
catastrophic risk, it is best to hold back on debt.
Competition: All else held constant, the more competitive the
business, the more risk you face in earnings.
Product type: Products that change quickly or have short life cycles
expose you to more bankruptcy risk.
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II. The Cost of Bankruptcy


Direct costs: If a company’s assets are liquid and
easily marketable, it should face less direct cost in
liquidation than if its assets are illiquid, unique or
have few buyers.
Indirect costs: The more damage that can be done to
both revenues and operations by the perception that
you are in trouble, the greater the indirect
bankruptcy cost.
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Agency Costs
Think like a lender!
1.
2.
3.
Type of assets: The more easily you can observe the
assets that your lending is used to acquire, the more
comfortable you feel lending money to a firm.
Companies with more physical, fixed assets should
have higher debt ratios than companies with intangible
assets.
Monitoring: The more easily you can monitor how a
firm invests and spends its money, the more
comfortable you feel about lending money.
History: The more “good” history a firm has in
borrowing money and returning the money, the more
comfortable you feel lending your money.
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Loss of flexibility
Future financing needs


Amount of future financing needs: A firm that has
less future financing needs should be able to borrow
more money than one that has more.
Predictability of future financing needs: A firm that
has more volatility in its financing needs will borrow
less than one that has a predictable financing need.
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