Slide strategic financial management l10

STRATEGIC FINANCIAL MANAGEMENT
The Trade off of Debt
KHURAM RAZA
ACMA, MS FINANCE


First Principle and Big Picture


The Trade off of Debt
Why use debt instead of equity?
The Benefits of Debt
 Debt Has A Tax Advantage
 Annual Tax Savings arising from the Interest Payment = t r B

 Present Value of Tax Savings from Debt = t r B / r = t B
 Value of Levered Firm with debt B = Value of
Unlevered Firm + t B
 After-tax Cost of Debt (k) = r (1 - t)d


The Trade off of Debt
Why use debt instead of equity?
The Benefits of Debt
 Debt make Managers more Disciplined
 Borrowing creates the commitment to make interest and
principal payments, increasing the risk of default on
projects with sub-standard returns


The Trade off of Debt

Why use debt instead of equity?
The Costs of Debt
 Debt increases expected bankruptcy costs
The Probability of Bankruptcy
 Size of operating cash flows relative to size of cash flows on debt
obligations
 Variance in Operating Cash Flows

The Cost of Bankruptcy
 Direct Costs
 Indirect Costs


The Trade off of Debt
Why use debt instead of equity?
The Costs of Debt

Debt creates agency costs
 equity investors generally control the firm’s management and decision making, their
interests will dominate bondholder interests unless bondholders take some
protective action. By borrowing money, a firm exposes itself to this conflict and its
negative consequences and it pays the price in terms of both higher interest rates
and a loss of freedom in decision making.
 The conflict between bondholder and stockholder interests appears in all three
aspects of corporate finance
 deciding what projects to take (making investment decisions),
 choosing how to finance these projects and
 determining how much to pay out as dividends:

The Trade-off in a Balance Sheet Format
Advantages of Borrowing
1. Tax Benefit:
Higher tax rates --> Higher tax benefit

2. Added Discipline:
Greater the separation between
managers
and stockholders --> Greater the benefit

Disadvantages of Borrowing

1. Bankruptcy Cost:
Higher business risk --> Higher Cost

2. Agency Cost:
Greater the separation between stockholders and lenders --> Higher Cost


Optimal Capital Mix
We have just argued that debt has advantages, relative to equity,
as well as disadvantages. Will trading off the costs and benefits of
debt yield an optimal mix of debt and equity for a firm?

 Modigliani-Miller Theorem.
Miller and Modigliani drew their conclusions in a world void of
taxes, transactions costs, and the possibility of default. Based
upon these assumptions,
they concluded that the
value of a firm was

unaffected by its leverage


Optimal Capital Mix
Relevance of Tax Benefits

Value of Levered Firm = Value of Unlevered Firm + t B

Relevance of Bankruptcy Cost
Higher Business Risk
Higher Equity Return
Higher Debt COst


Arbitrage


Arbitrage

Investment
Equity
Debt
Return
Interest

NL

L
400
300

400
-

100
36

64
-


How Firms Choose their Capital Structures
1. Financing Mix and a Firm’s Life Cycle
2. Financing Mix based on Comparable Firms
3. Following A Financing Hierarchy
 flexibility and control
 Costs of issuance
 Signaling impact