Lecture Note Packet 2
Capital Structure, Dividend Policy and Valuation
Capital Structure: The Choices and the
Neither a borrower nor a lender be
Someone who obviously hated this part of corporate finance
The Choices in Financing
There are only two ways in which a business can make money.
• The first is debt. 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.
• The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments.
Global Patterns in Financing…
And a much greater dependence on bank loans outside the
Assessing the existing financing choices: Disney, Aracruz
and Tata Chemicals
Financing Choices across the life cycle
to firm value.
to firm value.
Declining, as a
percent of firm
Low, relative to
High, relative to
More than funding needs
Accessing private equity
Inital Public offering
Seasoned equity issue
Low, as projects dry
The Transitional Phases..
The transitions that we see at firms – from fully owned private businesses to venture capital, from private to public and subsequent seasoned offerings are all motivated primarily by the need for capital.
In each transition, though, there are costs incurred by the existing owners:
• When venture capitalists enter the firm, they will demand their fair share and more of the ownership of the firm to provide equity.
• When a firm decides to go public, it has to trade off the greater access to capital markets against the increased disclosure requirements (that emanate from being publicly lists), loss of control and the transactions costs of going public.
• When making seasoned offerings, firms have to consider issuance costs while managing their relations with equity research analysts and rat
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). The resulting debt ratios can be very different.
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?
– What are the benefits of using debt instead of equity?
– What are the costs of using debt instead of equity?
• If not, why not?
Costs and Benefits of Debt
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