Thursday, September 9, 2010

Capital Structure: Optimal or Opportunisitic?

Contrary to the prediction of doomsayers during the banking crisis of 2008, firms seem to be returning with a vengeance to the debt markets. Today's story in the Wall Street Journal provides some details:

Finding the right mix of debt and equity to fund a business remains one of the key components of corporate finance. The contours of the choices are clearly established.
On the plus side: Using debt instead of equity to fund investments generates tax benefits in most countries, since interest expenses are tax deductible and dividends are not. Debt may also provide some "discipline" to managers of mature companies with large positive cash flows.
On the minus side: Debt increases the possibility of financial distress and/or bankruptcy, with all its potential costs. The tussle between whats good for stockholders and bondholders' interests manifests itself in covenants that restrict investment and financing choices and in monitoring costs.
 There are tools for assessing optimal capital structure as well. One is the cost of capital; in effect, the mix of debt and equity that yields the lowest cost of capital is the "optimal" mix. Another is Adjusted Present Value (APV), where a firm is first valued as if it were all equity funded (unlevered) and the net value added from debt is computed as the difference between the tax benefits and the expected bankruptcy costs. The mix that maximizes overall firm value is the "optimal" mix.

So, what has changed between a few months ago and now that would explain this surge of debt financing? It is unlikely that the tax benefits of borrowing have surged or that expected bankruptcy costs have dropped; the former explanation would have made sense if corporate tax rates were expected to rise in the future and the latter would have worked if the economy had strengthened significantly over the period.  I think the answer lies in evidence that behavioral finance has uncovered about how companies make financing decisions; my colleague at NYU, Jeff Wurgler, has the seminal paper on the topic. Rather than weigh the costs and benefits of debt and come up with optimal or target debt ratios, firms seem to make their financing choices based upon perceptions of the cheapness (or costliness) or debt as opposed to equity. Thus, they tend to flood the market with bond offerings, when they perceive the cost of debt to be low and with equity offerings, when they perceive their stock to be over priced. I would term this "opportunistic capital structure". The drop in treasury bond rates and the decline in default spreads (as the Greek crisis has receded) has led to much lower borrowing rates, especially for highly rated companies.

What's wrong with this? There are two potential dangers:
a. Perception may not be reality: Perceiving the cost of debt is low does not make it so. When CFOs make assessments of the relative costs of debt and equity, they are trying to be market timers. Given the sorry track record that portfolio managers have on timing equity and bond markets, I would be wary about CFOs who claim special powers on this issue.
b. Short term gain versus long term pain: Even if CFOs are good market timers and the cost of debt is low (relative to equity), is it a good idea to go out and fund your projects predominantly with debt? I don't think so. Over time, the firm will end up with too much debt, and over time, the cost of debt will revert back to historic norms. As with homeowners who borrowed because rates were low between 2004 and 2007, the day of reckoning will come and it will be painful.

Here is my compromise solution. Rather than pick an optimal or target debt ratio, a firm should choose a range for the optimal; in other words, a 20-40% optimal debt ratio, rather than 30%. Firms can then be opportunistic but only within this range; thus, you would move to a 40% debt ratio, if you believe that that the cost of debt is low or to a 20% debt ratio, if you think your equity is over priced. That would constrain over confident CFOs from pushing the debt ratio to unsustainable levels.


Rajiv said...

Makes sense, yet, I think there is a slight difference between the analogy of homeowners taking on more debt, when debt was cheap. The homeowners took on ever incresaing debt, but the assets being financed with so called cheap debt weren't cheap. In fact, home prices were surging...

At corporate level, the things are different atleast today... the new projects which can be financed with debt, are "cheaper" to construct /build... because of overcapacity in the contracting/supplier markets... So, unlike home owners, the cheap debt advantage is not overshadowed by high asset prices... my 2 cents!

The idea of optimal range of leverage is interesting and seems better - at least prima facie - than current practice!

Aswath Damodaran said...

You are right, but only in part. When interest rates become abnormally low, the value of the assets funded by debt also will increase proportionately. Think of it as a present value problem.

What I am trying to say is that the housing bubble and abnormally low interest rates are interlinked phenomenon. I think that low interest rates helped create the housing bubble, which in turn led to more borrowing.. A vicious and dangerous cycle.

Unknown said...

Dear Damodaran,

Thanks for your post.

In Brazil there is a tax benefit called "Interest on Equity".

This benefit allows companies in the so-called "real profit regime" to treat as interest expense (CIT deductible) the remuneration of the shareholder’s equity (today limited to 6% per year on previous year shareholder’s equity less dividends paid in the period).

These deductible interests on equity payment are taxed at 15% (withholding tax that net down shareholders earnings) while the real accounting profit would be taxed at ~34% for the company, leaving then the dividends net of tax for shareholders, a gain of ~19%, therefore.

What is the proper way of including this benefit into the valuation? Should we adjust the cost of equity to reflect this benefit? Is it appropriate to also include this in the terminal value calculation?

Thanks in advance.

Best Regards,

Aswath Damodaran said...

I am aware of the "interest on capital" deduction, computed as a percent of book equity, in Brazil. In effect, it gives equity a tax benefit as well. Holding all else constant, Brazilian firms should use less debt than firms in other countries.

In valuation, we should be adjusting the cost of equity for the tax benefit, just as we do the cost of debt.

Balaji said...

Why there is very little written about the re-financing of debt? Suppose I take a debt at say 5% and earn a 30% return on the investment, would I still be able to refinance the debt at the same 5% at the end of the term? Wouldn't it be logical for the lender to ask for a higher rate to make more money?

Aswath Damodaran said...

Why would your making more money have any effect on the lender? In fact, I wwould expect him to ask for a lower interest rate, because you would be safer.

Karthi said...

It was a decade long of cheap debt fuelled binge that propagated it into the housing bubble.

Rajiv, what you said holds true to some extent in Australia due to tax benefits associated with the negatively geared properties. Investors using property and taking on excessive debt for tax purposes and to bet on the property market regardless of how cheap or expensive it is relatively or in absolute terms.

Prof Whets your view on the Australian system that provides tax benefits on housing investments through negative gearing.

Dushyant said...

Professor Damodaran:

I will agree with this article in Forbes:

It's time to delete the CAPM from business school textbooks. The theory has done more harm than good for investors. Ever since the 1980s CAPM has been widely accepted by almost all sophisticated trading and money management firms practicing Modern Portfolio Theory to price stocks. It's baked into most Wall Street computer models. Indeed, most of the big firms and their chief risk officers focus on beta but--at least until recently--have ignored most other types of risks. Little things like leverage and liquidity. I believe that this contributed to the severity of at least three major crashes since the 1980s: the Crash of 1987, Long-Term Capital in 1998 and the subprime debacle we are still working through.

Balaji said...

@Dushyant - It is the assumptions that did not work not the theory as such! People remember the theory but forget the assumptions!
Professor - Do you believe that my money making will have no impact on the lender? If I am the lender, wouldn't I try to get the best out of the borrower?

Anonymous said...


I have a doubt related to capital structure.

I am using FCFF and rolling WACC to value a Company, which has one debt on its balance sheet. This debt will be fully amortized by 2020. When this happens, the capital structure will be 100% equity. Consequently, the WACC will increase by that year.

I would like to know the best approach to handle this situation. Should I: i) consider that the company will raise more debt after 2020 to maintain the current capital structure; or ii) should I let the balance sheet fully deleverage?

This decision impacts the company’s value.

Have you written any paper on this topic? I searched your website, but could not find it.