Aswath Damodaran – Debt and Value: Beyond Miller-Modigliani
The fundamental question: Does the mix of debt and equity affect the value of a business?
Debt and Value in Equity Valuation
Will the value of equity per share increase as debt increases?
Debt and Value in Firm Valuation
Will the value of operating assets increase as debt goes up?
A basic proposition about debt and value
For debt to affect value, there have to be tangible benefits and costs associated with using debt instead of equity.
- If the benefits exceed the costs, there will be a gain in value to equity investors from the use of debt.
- If the benefits exactly offset the costs, debt will not affect value
- If the benefits are less than the costs, increasing debt will lower value
Debt: The Basic Trade Off
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 & lenders –> Higher Cost
3. Loss of Future Financing Flexibility:
Greater the uncertainty about future financing needs –> Higher Cost
A Hypothetical Scenario
(a) There are no taxes
(b) Managers have stockholder interests at hear and do what’s best for stockholders.
(c) No firm ever goes bankrupt
(d) Equity investors are honest with lenders; there is no subterfuge or attempt to find loopholes in loan agreements
(e) Firms know their future financing needs with certainty
What happens to the trade off between debt and equity? How much should a firm borrow?
The Miller-Modigliani Theorem
In an environment, where there are no taxes, default risk or agency costs, capital structure is irrelevant.
The value of a firm is independent of its debt ratio and the cost of capital will remain unchanged as the leverage changes.
But here is the real world…
In a world with taxes, default risk and agency costs, it is no longer true that debt and value are unrelated.
In fact, increasing debt can increase the value of some firms and reduce the value of others.
For the same firm, debt can increase value up to a point and decrease value beyond that point.
Tools for assessing the effects of debt
The Cost of Capital Approach: The optimal debt ratio is the one that minimizes the cost of capital for a firm.
The Adjusted Present Value Approach: The optimal debt ratio is the one that maximizes the overall value of the firm.
The Sector Approach: The optimal debt ratio is the one that brings the firm closes to its peer group in terms of financing mix.
The Life Cycle Approach: The optimal debt ratio is the one that best suits where the firm is in its life cycle.
I. The Cost of Capital Approach
Value of a Firm = Present Value of Cash Flows to the Firm, discounted back at the cost of capital.
If the cash flows to the firm are held constant, and the cost of capital is minimized, the value of the firm will be maximized.
Measuring Cost of Capital
It will depend upon:
- (a) the components of financing: Debt, Equity or Preferred stock
- (b) the cost of each component
In summary, the cost of capital is the cost of each component weighted by its relative market value.
WACC = Cost of Equity (Equity / (Debt + Equity)) + After-tax Cost of debt (Debt/(Debt + Equity))
What is debt…
General Rule: Debt generally has the following characteristics:
- Commitment to make fixed payments in the future
- The fixed payments are tax deductible
- Failure to make the payments can lead to either default or loss of control of the firm to the party to whom payments are due.
Using this principle, you should include the following in debt
- All interest bearing debt, short as well as long term
- The present value of operating lease commitments