The Debt/equity tradeoff

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The Debt/equity tradeoff Aswath Damodaran

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The Debt/equity tradeoff. Aswath Damodaran. The trade off on debt versus equity. 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 - PowerPoint PPT Presentation

Transcript of The Debt/equity tradeoff

Page 1: The Debt/equity tradeoff

The Debt/equity tradeoff

Aswath Damodaran

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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 ratesIn 2012

Black #: Total ERPRed #: Country risk premiumAVG: GDP weighted average

Angola 35%Botswana 22%Egypt 25%Kenya 30%Mauritius 15%Namibia 34%Nigeria 30%South Africa 34.6%Tunisia 30%Zambia 35%Africa 29%

Belgium 33.99%Germany 29.48%Portugal 25%Italy 31.4%Luxembourg 28.8%Austria 25%Denmark 25%France 33.3%Finland 24.5%Greece 20%Iceland 20%Ireland 12.5%

Netherlands 25%Norway 28%Slovenia 18%Spain 30%Sweden 26.3%Switzerland 21.2%Turkey 20%UK 24%W.Europe 22.6%

Canada 26%USA 40%N. America 33%

Bahrain 0%Israel 25%Jordan 14%Kuwait 15%Libya 20%Oman 12%Qatar 10%Saudi Arabia 20%Middle East 14%

Albania 10%Armenia 20%Belarus 18%Bosnia & Herzegovina 10%Bulgaria 10%Croatia 20%Czech Republic 19%Estonia 21%Georgia 0%Hungary 19%Kazakhstan 20%Latvia 15%Lithuania 15%Montenegro 9%Poland 19%Romania 16%Russia 20%Slovakia 19%Slovenia 18%Ukraine 21%E. Europe & Russia 20.5%

Bangladesh 27.5%Cambodia 20%China 25%Fiji Islands 28%Hong Kong 16.5%India 32.5%Indonesia 25%Japan 38%Korea 24.2%Malaysia 25%Pakistan 35%Papua New Guinea 30%Philippines 30%Singapore 17%Sri Lanka 28%Taiwan 17%Thailand 23%Vietnam 25%Asia 22.9%

Australia 30%New Zealand 28%Australia & NZ 29%

Argentina 35%Bolivia 25%Brazil 34%Chile 18.5%Colombia 33%Costa Rica 30%Ecuador 23%El Salvador 30%Guatemala 31%Honduras 35%Mexico 30%Panama 25%Paraguay 10%Peru 30%Uruguay 25%Venezuela 34%Latin America 28.3%5

Bahamas 0.00%Bermuda 0.00%Bonaire 0.00%Cayman Islands 0.00%Georgia 0.00%Guernsey 0.00%Isle of Man 0.00%Jersey 0.00%

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Industry name Tax rate Industry name Tax rate Industry name Tax rate Industry name Tax rateAdvertising 32.82% Electrical Equipment 25.00% Machinery 28.47% R.E.I.T. 6.75%Aerospace/Defense 30.74% Electronics 22.26% Maritime 17.65% Railroad 31.78%Air Transport 31.82% Engineering & Const 38.23% Med Supp Invasive 29.81% Recreation 30.40%Apparel 33.28% Entertainment 27.43% Med Supp Non-Invasive 27.13% Reinsurance 14.88%Auto Parts 30.29% Entertainment Tech 20.67% Medical Services 34.76% Restaurant 27.82%Automotive 17.11% Environmental 26.91% Metal Fabricating 34.47% Retail (Hardlines) 32.79%Bank 24.92% Financial Svcs. (Div.) 31.17% Metals & Mining (Div.) 32.14% Retail (Softlines) 34.66%Bank (Midwest) 24.78% Food Processing 32.51% Natural Gas (Div.) 28.85% Retail Automotive 34.57%Beverage 32.52% Foreign Electronics 37.69% Natural Gas Utility 36.69% Retail Building Supply 39.97%Biotechnology 20.48% Funeral Services 32.15% Newspaper 27.30% Retail Store 35.25%Building Materials 26.15% Furn/Home Furnishings 25.84% Office Equip/Supplies 31.59% Retail/Wholesale Food 34.37%Cable TV 37.23% Healthcare Information 38.51% Oil/Gas Distribution 25.78% Securities Brokerage 44.89%Chemical (Basic) 25.68% Heavy Truck & Equip 23.97% Oilfield Svcs/Equip. 25.81% Semiconductor 21.72%Chemical (Diversified) 26.32% Homebuilding 35.07% Packaging & Container 27.51% Semiconductor Equip 15.91%Chemical (Specialty) 26.64% Hotel/Gaming 31.30% Paper/Forest Products 17.71% Shoe 31.23%Coal 17.27% Household Products 30.67% Petroleum (Integrated) 35.29% Steel 33.30%Computer Software 25.35% Human Resources 37.10% Petroleum (Producing) 24.60% Telecom. Equipment 28.32%Computers/Peripherals 23.26% Industrial Services 37.37% Pharmacy Services 31.87% Telecom. Services 30.64%Diversified Co. 28.09% Information Services 27.31% Pipeline MLPs 11.79% Telecom. Utility 38.10%Drug 18.67% Insurance (Life) 28.84% Power 33.64% Thrift 27.52%E-Commerce 27.19% Insurance (Prop/Cas.) 20.89% Precious Metals 30.29% Tobacco 37.16%Educational Services 32.70% Internet 29.30% Precision Instrument 24.56% Toiletries/Cosmetics 31.90%Electric Util. (Central) 32.00% Investment Companies 20.06% Property Management 34.40% Trucking 36.73%Electric Utility (East) 33.57% IT Services 23.93% Public/Private Equity 23.29% Water Utility 34.63%Electric Utility (West) 30.05% Machinery 28.47% Publishing 39.57% Wireless Networking 28.11%

Total Market 28.37%

Effective tax rates across sectors: US in 2013

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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 CostI. 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 CostsThink like a lender!1. 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.

2. Monitoring: The more easily you can monitor how a firm invests and spends its money, the more comfortable you feel about lending money.

3. 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 flexibilityFuture 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.