FM-CH(4).ppt THE INVESTMENT DECISION THE INVESTMENT DECISION

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

2. Aswath Damodaran 3
Introduction:
Capitalstructureinsimplewordsreferstodebtequityratioofa
company.
Inotherwordsitreferstotheproportionofdebtintheinvestments
ofthecompany.Itisimportantforacompanytohaveanappropriate
capitalstructure.
Meaningofcapitalization:
Inbroadsense,capitalizationissynonymouswithfinancialplanning,
coveringdecisionsregardingtheamountofcapitaltoberaised,the
relativeproportionsofthevariousclassesofsecuritiestobeissued
andtheadministrationofcapital.

3. Aswath Damodaran 4
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

4. Aswath Damodaran 5
The Choices in Financing
Thereareonlytwowaysinwhichabusinesscanmakemoney.
Thefirstisdebt.Thespiritofdebtisthatyoupromisetomake
fixedpaymentsinthefuture(interestpaymentsandrepaying
principal).
Theotherisequity.Withequity,youdogetwhatevercashflows
areleftoverafteryouhavemadedebtpayments.

5. Aswath Damodaran 6
The Financing Mix Question
Indecidingtoraisefinancingforabusiness,is
thereanoptimalmixofdebtandequity?
•Ifyes,whatisthetradeoffthatletsusdeterminethis
optimalmix?
•Ifnot,whynot?

6. Aswath Damodaran 7
Measuring a firm’s financing mix
Thesimplestmeasureofhowmuchdebtandequityafirmisusing
currentlyistolookattheproportionofdebtinthetotalfinancing.
Thisratioiscalledthedebttocapitalratio:
DebttoCapitalRatio=Debt/(Debt+Equity)
Debtincludesallinterestbearingliabilities,shorttermaswellas
longterm.
Equitycanbedefinedeitherinaccountingterms(asbookvalueof
equity)orinmarketvalueterms(baseduponthecurrentprice).

7. Aswath Damodaran 8
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 shareholdersand management.
•Loss of Future Flexibility
Whenafirmborrowsuptoitscapacity,itlosestheflexibilityoffinancingfuture
projectswithdebt.
Otherthingsremainingequal,themoreuncertainafirmisaboutitsfuture
financingrequirementsandprojects,thelessdebtthefirmwilluseforfinancing
currentprojects.

8. Aswath Damodaran 9
Tax Benefits of Debt
When you borrow money, you are allowed to deduct interest expenses
from your incometo 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.

9. Aswath Damodaran 10
Debt adds discipline to management
Ifyouaremanagersofafirmwithnodebt,andyou
generatehighincomeandcashflowseachyear,youtend
tobecomeself-satisfied.
Thesatisfactioncanleadtoinefficiencyandinvestingin
poorprojects.Thereislittleornocostbornebythe
managers
Forcingsuchafirmtoborrowmoneycanbeanremedyto
thecomplacency.
Themanagersnowhavetoensurethattheinvestments
theymakewillearnatleastenoughreturntocoverthe
interestexpenses.Thecostofnotdoingsoisbankruptcy
andthelossofsuchajob.

10. Aswath Damodaran 11
Bankruptcy Cost
Theexpectedbankruptcycostisafunctionoftwo
variables--
•Thecostofgoingbankrupt
–directcosts:LegalandotherDeadweightCosts
–indirectcosts:Costsarisingbecausepeople
perceiveyoutobeinfinancialtrouble
•Theprobabilityofbankruptcy,whichwilldepend
uponhowuncertainyouareaboutfuturecashflows
–Otherthingsbeingequal,thegreatertheindirectbankruptcycost,the
lessdebtthefirmcanaffordtouse.

11. Aswath Damodaran 12
Agency Cost
Anagencycostariseswheneveryouhiresomeoneelsetodosomethingfor
you.Itarisesbecauseyourinterests(astheprincipal)maydeviatefrom
thoseofthepersonyouhired(astheagent).
Twocategoriesofagencycosts:
1.Costsincurredwhentheagent(managementteam)usesthecompany’sresources
forhisorherownbenefit/Corporateexpendituresthatbenefitthemanagement
teamattheexpenseofshareholders
2.Costsincurredbytheprincipals(shareholders)topreventtheagent(management
team)fromprioritizinghim/herselfovershareholderinterests/Anexpensethat
arisesfrommonitoringmanagementactionstokeeptheprincipal-agent
relationshipaligned

12. Aswath Damodaran 13
Loss of future financing flexibility
When a firm borrows up to its capacity, it loses the flexibility of
financing future projects with debt.
Otherthingsremainingequal,themoreuncertainafirmisaboutitsfuture
financingrequirementsandprojects,thelessdebtthefirmwilluseforfinancing
currentprojects.

13. Aswath Damodaran 14
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 = k
e
(E/(D+E)) + k
d
(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.

15. Aswath Damodaran 16
Why does the cost of capital matter?
ValueofaFirm=PresentValueofCashFlowstothe
Firm,discountedbackatthecostofcapital.
Ifthecashflowstothefirmareheldconstant,andthe
costofcapitalisminimized,thevalueofthefirmwillbe
maximized.

16. Aswath Damodaran 17
MeaningofFinancialLeverage
•Theuseofthefixed-chargessourcesoffunds,suchasdebtand
preferencecapitalalongwiththeowners’equityinthecapital
structure,isdescribedasfinancialleverageorgearingortrading
onequity.
•Thefinancialleverageemployedbyacompanyisintendedtoearn
morereturnonthefixed-chargefundsthantheircosts.
•Thesurplus(ordeficit)willincrease(ordecrease)thereturnonthe
owners’equity.
•Therateofreturnontheowners’equityisleveredaboveorbelow
therateofreturnontotalassets.
17

17. Aswath Damodaran 18
MeasuresofFinancialLeverage
Debt ratio, Debt–equity ratio &Interest coverage
•Thefirsttwomeasuresoffinancialleveragecanbeexpressedeither
intermsofbookvaluesormarketvalues.Thesetwomeasuresare
alsoknownasmeasuresofcapitalgearing.
•Thethirdmeasureoffinancialleverage,commonlyknownas
coverageratio.

18. Aswath Damodaran 19
Financial Leverage and the Shareholders’ Return
•Theprimarymotiveofacompanyinusingfinancialleverageisto
magnifytheshareholders’returnunderfavorableeconomic
conditions.
•Theroleoffinancialleverageinmagnifyingthereturnofthe
shareholders’isbasedontheassumptionsthatthefixed-charges
funds(suchastheloanfromfinancialinstitutionsandbanksor
debentures)canbeobtainedatacostlowerthanthefirm’srateof
returnonnetassets(RONAorROI).
•EPS,ROEandROIaretheimportantfiguresforanalyzingthe
impactoffinancialleverage.
19

19. Aswath Damodaran 20
THEORIESOFCAPITALSTRUCTURE
•NetIncome(NI) Theory
•NetOperatingIncome(NOI)Theory
•TraditionalTheory
•Modigliani-Miller(M-M)Theory

20. Aswath Damodaran 21
NETINCOME(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 capitalby increasing the proportion of debt in its capital structure to
the maximum possible extent.
⚫It is due to the fact that debtis, generally a cheapersource 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.

21. Aswath Damodaran 22
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.

22. Aswath Damodaran 23
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

23. Aswath Damodaran 24
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 debenturesby Rs.4,00,000 and uses
the proceeds to repurchase equity shares.
(ii)The firm decides to redeem the debenturesof Rs. 4,00,000 by issue of Equity
shares.

24. Aswath Damodaran 25
NetOperatingIncomeTheory
•This theory was propounded by “DavidDurand” 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.

25. Aswath Damodaran 26
AssumptionsofNOITheory
•The splitof total capitalization between debt and equity is
not essential or relevant.
•Theequityshareholdersandotherinvestorsi.e.themarket
capitalizesthevalueofthefirmasawhole.
•Thebusinessriskateachlevelofdebt-equitymixremains
constant.Therefore,overallcostofcapitalalsoremains
constant.
•The corporate income tax does not exist.

26. Aswath Damodaran 27
TraditionalTheory
ThistheoryissimilarwithNETINCOME(NI)THEORY&was
propoundedbyEzraSolomon.
Accordingtothistheory,afirmcanreducetheoverall
costofcapitalorincreasethetotalvalueofthefirmby
increasingthedebtproportioninitscapitalstructuretoa
certainlimit.
DebtisAcheapsourceofraisingfundsascomparedto
equitycapital.

27. Aswath Damodaran 28
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.

28. Aswath Damodaran 29
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,
offsetthe 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.

29. Aswath Damodaran 30
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

30. Aswath Damodaran 31
IntheAbsence ofCorporateTaxes
•Accordingtothisapproachthe‘V’andits‘Ko’areindependentofits
capitalstructure.
•Thedebt-equitymixofthefirmisirrelevantindeterminingthetotal
valueofthefirm.
•Becausewithincreaseduseofdebtasasourceoffinance,‘Ke’
increasesandtheadvantageoflowcostdebtisoffsetequallybythe
increased‘Ke’.
•Intheopinionofthem,twoidenticalfirmsinallrespect,excepttheir
capitalstructure,cannothavedifferentmarketvalueorcostof
capitalduetoArbitrageProcess.

31. Aswath Damodaran 32
Assumptions ofM-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.

32. Aswath Damodaran 33
WhenCorporateTaxes
Exist
M-M’soriginalargumentthatthe‘V’and‘Ko’remain
constantwiththeincreaseofdebtincapitalstructure,does
notholdgoodwhencorporatetaxesareassumedtoexist.
•Theyrecognizedthatthe‘V’willincreaseand‘Ko’will
decreasewiththeincreaseofdebtincapitalstructure.
•Theyacceptedthatthevalueoflevered(VL)firmwillbe
greaterthanthevalueofunleveredfirm(Vu).

33. Aswath Damodaran 34
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

34. Aswath Damodaran 35
EPSandROE 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.
219

36. Aswath Damodaran 37
Effect of Financial Plan on EPS and
ROE: Constant EBIT

37. Aswath Damodaran 38
InterestTaxShield
Theinterestchargesaretaxdeductibleand,
therefore,providetaxshield,whichincreases
theearningsoftheshareholders.
38

38. Aswath Damodaran 39
Effectof LeverageonROEand EPS
Favourable ROI>i
Unfavourable
Neutral
39
ROI<i
ROI=i

39. Aswath Damodaran 40
Calculationof indifferencepoint
•TheEPS formulaunder all-equityplanis
•TheEPSformulaunderdebt–equityplanis:
•Settingthetwoformulaeequal,wehave:
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:
Thefirmmaycomparebetweenanall-equityplanandan
equity-and-preferenceshareplan.Thentheindifferencepoint
formulawillbe:
Calculationof indifferencepoint
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