Corporate Finanace

Topics: Corporate finance, Generally Accepted Accounting Principles, Capital requirement Pages: 216 (18208 words) Published: October 30, 2014
Corporate Finance
Lecture Note Packet 2
Capital Structure, Dividend Policy and Valuation


Aswath Damodaran

Aswath Damodaran!


Capital Structure: The Choices and the
Trade off

Neither a borrower nor a lender be

Someone who obviously hated this part of corporate finance

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First Principles

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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 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.

Aswath Damodaran!


Global Patterns in Financing…

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And a much greater dependence on bank loans outside the

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Assessing the existing financing choices: Disney, Aracruz
and Tata Chemicals

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Financing Choices across the life cycle

$ Revenues/


External funding

High, but
constrained by

High, relative
to firm value.

Moderate, relative
to firm value.

Declining, as a
percent of firm

Internal financing

Negative or

Negative or

Low, relative to
funding needs

High, relative to
funding needs

More than funding needs


Owner’s Equity
Bank Debt

Venture Capital
Common Stock

Common stock


Retire debt
Repurchase stock

Growth stage

Stage 1

Stage 2
Rapid Expansion

Stage 4
Mature Growth

Stage 5


Aswath Damodaran!

Accessing private equity

Inital Public offering

Stage 3
High Growth

Seasoned equity issue

Low, as projects dry

Bond issues


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

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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). The resulting debt ratios can be very different.

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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?

–  What are the benefits of using debt instead of equity?

–  What are the costs of using debt instead of equity?

•  If not, why not?

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Costs and Benefits of Debt



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