Finding the Right Financing Mix: The
Capital Structure Decision
Aswath Damodaran
Stern School of Business
Aswath Damodaran / Edited by Del Hawley
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The Only Two Choices for Financing


Debt (Leverage)
• The essence of debt is that you promise to make fixed
payments in the future (interest payments and repaying
principal). If you fail to make those payments, you lose
control of your business.
Equity
• With equity, you do get whatever cash flows are left
over after you have made debt payments.
Aswath Damodaran / Edited by Del Hawley
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Debt versus Equity
Debt
Equity
Fixed Claim
Residual Claim
High Priority on Cash
Flows
Interest is Tax Deductible
Lowest Priority on Cash
Flows
No Tax Break on
Dividends
Fixed Maturity
Infinite Life
Aswath Damodaran / Edited by Del Hawley
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When Is It Debt?
Ask 3 Questions:
1. Is the cashflow claim created by this financing a
fixed commitment or a residual claim?
2. Is the commitment tax-deductible?
3. If you fail to uphold the commitment, do you lose
control of the business?
If all three answers are “Yes”, it’s debt.
Otherwise, it’s equity or a hybrid.
Aswath Damodaran / Edited by Del Hawley
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Cost of Debt
Debt is always the least
costly form of financing.
WHY?
Aswath Damodaran / Edited by Del Hawley
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Cost of Debt vs. Equity
E(R)
Equity
Rf
Debt will always be perceived
by investors to be less risky
than equity. Therefore, its
required return will always be
lower.
Debt
β
Aswath Damodaran / Edited by Del Hawley
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Cost of Debt vs. Equity
AND,
Interest on debt is tax deductible, thus lowering the cost
of debt even farther.
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Debt versus Equity
Factor
Cost
Debt
Lowest
High: Bankruptcy
Risk to the Firm and volatility of
cashflows
High: Major
Impact on
restrictions on
Flexibility
decision making
Impact on
Control
Aswath Damodaran / Edited by Del Hawley
Low, unless firm is
in bankruptcy
Equity
Highest
Low
Low: Few
restrictions on
decision making
Potentially High:
Many owners
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The Choices


Equity can take different forms:
• Small business owners investing their savings
• Venture capital for startups
• Common stock for corporations
Debt can also take different forms
• For private businesses, it is usually bank loans
• For publicly traded firms, it is more likely to be
debentures (bonds) for long-term debt and commercial
paper for short-term debt
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Compare Advantages and Disadvantages
of Debt
Advantages of Debt
• Interest is tax-subsidized  Low cost
• Increases upside variability of cashflows to equity
• Adds discipline to management
Disadvantages of Debt
• Possibility of bankruptcy/financial distress
• Increases downside variability of cashflows to equity
• Agency costs are incurred
• Loss of future flexibility
Aswath Damodaran / Edited by Del Hawley
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What Does Leverage Mean?
Depending on where the
fulcrum is placed, a small
force can be amplified into a
much larger force.
Aswath Damodaran / Edited by Del Hawley
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What Does Leverage Mean?
In financial leverage, the
fulcrum is the fixed cost of
the debt financing.
The small force is
variability of
operating income.
The large force is the variability of
cashflows to shareholders (EPS)
Aswath Damodaran / Edited by Del Hawley
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What Does Leverage Mean?
The larger the fixed interest
payments…
The more a small
change in
operating profit…
Will be amplified into a larger
change in EPS
Aswath Damodaran / Edited by Del Hawley
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What Does Leverage Mean?
See the example spreadsheet
linked to the class web page
for a demonstration of
financial leverage.
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What managers consider important in deciding
on how much debt to carry...
A survey of Chief Financial Officers of large U.S. companies
provided the following ranking (from most important to least
important) for the factors that they considered important in the
financing decisions
Factor
Ranking (0-5)
1. Maintain financial flexibility
4.55
2. Ensure long-term survival
4.55
3. Maintain Predictable Source of Funds
4.05
4. Maximize Stock Price
3.99
5. Maintain financial independence
3.88
6. Maintain high debt rating
3.56
7. Maintain comparability with peer group
2.47
Aswath Damodaran / Edited by Del Hawley
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How do firms set their financing mixes?



Life Cycle: Some firms choose a financing mix that
reflects where they are in the life cycle; start- up firms use
more equity, and mature firms use more debt.
Comparable firms: Many firms seem to choose a debt
ratio that is similar to that used by comparable firms in the
same business.
Financing Hierarchy: Firms also seem to have strong
preferences on the type of financing used, with retained
earnings being the most preferred choice. They seem to
work down the preference list, rather than picking a
financing mix directly.
Aswath Damodaran / Edited by Del Hawley
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Rationale for Financing Hierarchy


Managers value flexibility. External financing reduces
flexibility more than internal financing.
Managers value control. Issuing new equity weakens
control and new debt creates bond covenants.
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Preference rankings : Results of a survey
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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Why does the cost of capital matter?


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.
So, if capital structure changes do not affect the cost
of capital, then capital structure is irrelevant since it
will not affect firm value.
Aswath Damodaran / Edited by Del Hawley
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The Most Realistic View of Capital Structure…
70%
60%
50%
40%
Ke
30%
Kd(1-Tx)
20%
WACC
10%
0%
-
0.10
0.20
Aswath Damodaran / Edited by Del Hawley
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
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The Most Realistic View of Capital Structure…
The tax advantage of debt would be progressively
offset by the rising potential for bankruptcy and the
resulting financial distress costs, and also by the rising
agency costs.
The result would be that the WACC would fall as debt
went from zero to some larger amount, but would
eventually reach a minimum and then start to climb.
Thus, there would be an optimal capital structure
where the WACC is minimized. This would be less
that 100% debt.
Aswath Damodaran / Edited by Del Hawley
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