THE INVESTMENT DECISION THE INVESTMENT DECISION

1. Aswath Damodaran 2
.
1. List and explain at least two theories
of financing.
2. How to determine optimal capital
structure

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Introduction:
Capital structure in simple words refers to debt equity ratio of a
company.
In other words it refers to the proportion of debt in the investments
of the company. It is important for a company to have an appropriate
capital structure.
Meaning of capitalization:
In broad sense, capitalization is synonymous with financial planning,
covering decisions regarding the amount of capital to be raised, the
relative proportions of the various classes of securities to be issued
and the administration of capital.

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First Principles
 Choose a financing mix that minimizes the burden rate
and matches the assets being financed.
 If there are not enough investments that earn the burden
rate , return the cash to stockholders.
 The form of returns
Dividends and stock buybacks - will depend upon the
stockholders’ characteristics.
Objective: Maximize the Value of the Firm

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The Choices in Financing
 There are only two ways in which a business can make money.
 The first is debt. The spirit of debt is that you promise to make
fixed payments in the future (interest payments and repaying
principal).
 The other is equity. With equity, you do get whatever cash flows
are left over after you have made debt payments.

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The Financing Mix Question
 In deciding to raise financing for a business, is
there an optimal mix of debt and equity?
• If yes, what is the trade off that lets us determine this
optimal mix?
• If not, why not?

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Measuring a firm’s financing mix
 The simplest measure of how much debt and equity a firm is using
currently is to look at the proportion of debt in the total financing.
This ratio is called the debt to capital ratio:
Debt to Capital Ratio = Debt / (Debt + Equity)
 Debt includes all interest bearing liabilities, short term as well as
long term.
 Equity can be defined either in accounting terms (as book value of
equity) or in market value terms (based upon the current price).

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Costs and Benefits of Debt
 Benefits of Debt
• Tax Benefits
• Adds discipline to management
 Costs of Debt
• Bankruptcy Costs/Compliance and professional fees and time
• Agency Costs/Conflicts of interest between shareholders and management.
• Loss of Future Flexibility
 When a firm borrows up to its capacity, it loses the flexibility of financing future
projects with debt.
 Other things remaining equal, the more uncertain a firm is about its future
financing requirements and projects, the less debt the firm will use for financing
current projects.

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Tax Benefits of Debt
 When you borrow money, you are allowed to deduct interest expenses
from your income to arrive at taxable income. This reduces your taxes.
 When you use equity, you are not allowed to deduct payments to equity
(such as dividends) to arrive at taxable income.
 The dollar tax benefit from the interest payment in any year is a function
of your tax rate and the interest payment:
• Tax benefit each year = Tax Rate * Interest Payment
 Other things being equal, the higher the marginal tax rate of a business, the more
debt it will have in its capital structure.

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Debt adds discipline to management
 If you are managers of a firm with no debt, and you
generate high income and cash flows each year, you tend
to become self-satisfied.
 The satisfaction can lead to inefficiency and investing in
poor projects. There is little or no cost borne by the
managers
 Forcing such a firm to borrow money can be an remedy to
the complacency.
 The managers now have to ensure that the investments
they make will earn at least enough return to cover the
interest expenses. The cost of not doing so is bankruptcy
and the loss of such a job.

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Bankruptcy Cost
 The expected bankruptcy cost is a function of two
variables--
• The cost of going bankrupt
–direct costs: Legal and other Deadweight Costs
–indirect costs: Costs arising because people
perceive you to be in financial trouble
• The probability of bankruptcy, which will depend
upon how uncertain you are about future cash flows
– Other things being equal, the greater the indirect bankruptcy cost, the
less debt the firm can afford to use.

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Agency Cost
 An agency cost arises whenever you hire someone else to do something for
you. It arises because your interests(as the principal) may deviate from
those of the person you hired (as the agent).
 Two categories of agency costs:
1. Costs incurred when the agent (management team) uses the company’s resources
for his or her own benefit/Corporate expenditures that benefit the management
team at the expense of shareholders
2. Costs incurred by the principals (shareholders) to prevent the agent (management
team) from prioritizing him/herself over shareholder interests/An expense that
arises from monitoring management actions to keep the principal-agent
relationship aligned

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Loss of future financing flexibility
 When a firm borrows up to its capacity, it loses the flexibility of
financing future projects with debt.
 Other things remaining equal, the more uncertain a firm is about its future
financing requirements and projects, the less debt the firm will use for financing
current projects.

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Measuring Cost of Capital
 It will depend upon:
• (a) the components of financing: Debt, Equity or
Preferred stock
• (b) the cost of each component
 In summary, the cost of capital is the cost of each
component weighted by its relative market value.
WACC = ke (E/(D+E)) + kd (D/(D+E))

14. Aswath Damodaran 15
Recapitulating the Measurement of cost of
capital
 The cost of debt is the market interest rate that the firm has to pay on its
borrowing. It will depend upon three components
(a) The general level of interest rates
(b) The default premium
(c) The firm's tax rate
 The cost of equity is
1. The required rate of return given the risk
2. Inclusive of both dividend yield and price appreciation
The weights attached to debt and equity have to be market value weights,
not book value weights.

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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.

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Meaning of Financial Leverage
• The use of the fixed-charges sources of funds, such as debt and
preference capital along with the owners’ equity in the capital
structure, is described as financial leverage or gearing or trading
on equity.
• The financial leverage employed by a company is intended to earn
more return on the fixed-charge funds than their costs.
• The surplus (or deficit) will increase (or decrease) the return on the
owners’ equity.
• The rate of return on the owners’ equity is levered above or below
the rate of return on total assets.
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17. Aswath Damodaran 18
Measures of Financial Leverage
Debt ratio, Debt–equity ratio &Interest coverage
• The first two measures of financial leverage can be expressed either
in terms of book values or market values. These two measures are
also known as measures of capital gearing.
• The third measure of financial leverage, commonly known as
coverage ratio.

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Financial Leverage and the Shareholders’ Return
• The primary motive of a company in using financial leverage is to
magnify the shareholders’ return under favorable economic
conditions.
• The role of financial leverage in magnifying the return of the
shareholders’ is based on the assumptions that the fixed-charges
funds (such as the loan from financial institutions and banks or
debentures) can be obtained at a cost lower than the firm’s rate of
return on net assets (RONA or ROI).
• EPS, ROE and ROI are the important figures for analyzing the
impact of financial leverage.
19

19. Aswath Damodaran 20
THEORIES OF CAPITAL STRUCTURE
• Net Income (NI) Theory
• Net Operating Income (NOI) Theory
• Traditional Theory
• Modigliani-Miller (M-M) Theory

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NET INCOME (NI) THEORY
⚫ This theory was propounded by “David-Durand” and is also known as “Fixed ‘Ke’
Theory”.
⚫ According to this theory a firm can increase the value of the firm and reduce the
overall cost of capital by increasing the proportion of debt in its capital structure to
the maximum possible extent.
⚫It is due to the fact that debt is, generally a cheaper source of funds
because:
(i) Interest rates are lower than dividend rates due to element of risk,
(ii)The benefit of tax as the interest is deductible expense for income tax purpose.

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Computation of the Total Value of the Firm
Total Value of the Firm (V) = S + D Where,
S = Market value of Shares = EBIT-I = E
Ke Ke
D = Market value of Debt = Face Value
E = Earnings available for equity shareholders
Ke = Cost of Equity capital or Equity capitalization rate.

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Computation of the Overall Cost of Capital or
Capitalization Rate
• Ko = EBIT
V
Where,
Ko = Overall Cost of Capital or Capitalization Rate
V = Value of the firm

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Case
• K.M.C. Ltd. Expects annual net income (EBIT) of
Rs.2,00,000 and equity capitalization rate of 10%. The
company has Rs.600,000; 8% Debentures. There is no
corporate income tax.
• (A) Calculate the value of the firm and overall (cost of
capital according to the NI Theory.
• (B) What will be the effect on the value of the firm and
overall cost of capital, if:
(i) The firm decides to raise the amount of debentures by Rs.4,00,000 and uses
the proceeds to repurchase equity shares.
(ii)The firm decides to redeem the debentures of Rs. 4,00,000 by issue of Equity
shares.

24. Aswath Damodaran 25
Net Operating Income Theory
• This theory was propounded by “David Durand” and is
also known as “Irrelevant Theory”.
• According to this theory,
 The total market value of the firm (V) is not affected by the
change in the capital structure
 The overall cost of capital (ko) remains fixed irrespective
of the debt-equity mix.

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Assumptions of NOI Theory
• The split of total capitalization between debt and equity is
not essential or relevant.
• The equity shareholders and other investors i.e. the market
capitalizes the value of the firm as a whole.
• The business risk at each level of debt-equity mix remains
constant. Therefore, overall cost of capital also remains
constant.
• The corporate income tax does not exist.

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Traditional Theory
This theory is similar with NET INCOME (NI) THEOR
Y & was
propounded by Ezra Solomon.
According to this theory, a firm can reduce the overall
cost of capital or increase the total value of the firm by
increasing the debt proportion in its capital structure to a
certain limit.
Debt is A cheap source of raising funds as compared to
equity capital.

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Effects of Changes in Capital Structure on
‘Ko’ and ‘V’
As per Ezra Solomon:
•First Stage: The use of debt in capital structure increases
the ‘V’and decreases the ‘Ko’.
• Because ‘Ke’remains constant or rises slightly with debt, but
it does not rise fast enough to offset the advantages of low
cost debt.
• ‘Kd’remains constant or rises very insignificantly.

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Effects of Changes in Capital Structure on
‘Ko’ and ‘V’
• Second Stage: During this Stage, there is a range in which
the ‘V’will be maximum and the ‘Ko’will be minimum.
– Because the increase in the ‘Ke’, due to increase in financial risk,
offset the advantage of using low cost of debt.
• Third Stage: The ‘V’ will decrease and the ‘Ko’ will
increase.
– Because further increase of debt in the capital structure, beyond
the acceptable limit increases the financial risk.

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Modigliani-Miller
Theory
• This theory was propounded by Franco
Modigliani and Merton Miller.
• They have given two approaches
In the Absence of Corporate Taxes
When Corporate Taxes Exist

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In the Absence of Corporate Taxes
• According to this approach the ‘V’ and its ‘Ko’are independent of its
capital structure.
• The debt-equity mix of the firm is irrelevant in determining the total
value of the firm.
• Because with increased use of debt as a source of finance, ‘Ke’
increases and the advantage of low cost debt is offset equally by the
increased ‘Ke’.
• In the opinion of them, two identical firms in all respect, except their
capital structure, cannot have different market value or cost of
capital due to Arbitrage Process.

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Assumptions of M-M
Approach
• Perfect Capital Market
• No Transaction Cost
• Homogeneous Risk Class: Expected EBIT of all the firms have
identical risk characteristics.
• Risk in terms of expected EBIT should also be identical for
determination of market value of the shares
• No Corporate Taxes: But later on in 1969 they removed this
assumption.

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When Corporate Taxes
Exist
M-M’s original argument that the ‘V’ and ‘Ko’remain
constant with the increase of debt in capital structure, does
not hold good when corporate taxes are assumed to exist.
• They recognized that the ‘V’ will increase and ‘Ko’ will
decrease with the increase of debt in capital structure.
• They accepted that the value of levered (VL) firm will be
greater than the value of unlevered firm (Vu).

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Computation
Value of Unlevered Firm
Vu = EBIT(1 – T)
Ke
Value of Levered Firm
VL = Vu + Dt
Where,
Vu : Value of Unlevered Firm
VL :Value of Levered Firm
D : Amount of Debt t : tax rate

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EPS and ROE Calculations
• For calculating ROE either the book value or the
market value equity may be used.
218

35. Aswath Damodaran 36
Analyzing Alternative Financial
Plans: Constant EBIT
The firm is considering two alternative financial plans:
–(i) either to raise the entire funds by issuing 50,000 ordinary
shares at Rs 10 per share, or
–(ii) to raise Rs 250,000 by issuing 25,000 ordinary shares at Rs 10
per share and borrow Rs 250,000 at 15 per cent rate of interest.
–EBIT is Rs 120,000 under two different financial planning scenario
–The tax rate is 50 per cent.
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36. Aswath Damodaran 37
Effect of Financial Plan on EPS and
ROE: Constant EBIT

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Interest Tax Shield
The interest charges are tax deductible and,
therefore, provide tax shield, which increases
the earnings of the shareholders.
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38. Aswath Damodaran 39
Effect of Leverage on ROE and EPS
Favourable ROI > i
Unfavourable
Neutral
39
ROI < i
ROI = i

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Calculation of indifference point
• The EPS formula under all-equity plan is
• The EPS formula under debt–equity plan is:
• Setting the two formulae equal, we have:
40

40. Aswath Damodaran 41
Sometimes a firm may like to make a choice between two
levels of debt. Then, the indifference point formula will be:
The firm may compare between an all-equity plan and an
equity-and-preference share plan. Then the indifference point
formula will be:
Calculation of indifference point
41

41. Aswath Damodaran 42
A Framework for Getting to the Optimal
Is the actual debt ratio greater than or lesser than the optimal debt ratio?
Actual > Optimal
Over levered
Actual < Optimal
Under levered
Is the firm under bankruptcy threat? Is the firm a takeover target?
Yes No
Reduce Debt quickly
1. Equity for Debt swap
2. Sell Assets; use cash
to pay off debt
3. Renegotiate with lenders
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital
Yes
Take good projects with
new equity or with retained
earnings.
No
1. Pay off debt with retained
earnings.
2. Reduce or eliminate dividends.
3. Issue new equity and pay off
debt.
Yes No
Does the firm have good
projects?
ROE > Cost of Equity
ROC > Cost of Capital
Yes
Take good projects with
debt.
No
Do your stockholders like
dividends?
Yes
Pay Dividends No
Buy back stock
Increase leverage
quickly
1. Debt-Equity swaps
2. Borrow money&
buy shares.

42. Aswath Damodaran 43
The End