2.2. Corporate Finance
Objective
+ Introduce the basic corporate accounting identity, A = E + L
+ Identify the two fundamental sources of funding for companies
+ Understand the nature of debt
+ Understand the nature of equity
Lecture: Capital Structure
Part I – The basis accounting identity and sources of funds
1. A company’s books must balance: the value of assets must equal the value of equity plus the value of debt. This relationship is captured in the so-called Accounting equation. (http://en.wikipedia.org/wiki/Accounting_equation): Assets = Equity + Liabilities
This financial equation is a huge simplification of the actual accounts of a company. (For example, here’s what Apple’s balance sheet looks like.)
2. Companies can either borrow money (debt,) or sell ownership of the company (equity.)
Debt
3. When companies issue debt, they borrow money and in return generally promise to pay regular interest on the amount borrowed, and the principle at the end of the term of the loan. (Check out the largest corporate debt issue in history.)
4. To the borrower, the obligation is to make the regular interest payments which requires cash on hand, and to pay back the principle when the term expires. So long as the company meets the debt requirements, it has no other obligations to lenders.
5. To the lenders, the risk is that the company will not be able to pay the regular interest, or pay back the principle. There is also the risk that the company will pay of the debt earlier than expected (but not all debt is of this kind known as callable.)
Equity
6. When companies issue stock they sell shares through an Initial Public Offering (IPO). These are not sold to the general public, but to large institutional investors and early private investors (these could be owners and employees.) When companies “go public” they do so through an IPO. (The five largest IPOs in history are identified here, with Alibaba, the Chinese Ebay topping the list.)
7. Many companies are not public, but still have shareholders. Private equity has become a large category of equity investment in companies that don’t want to be exposed to the regulation and scrutiny of a public company. (Here is an interesting podcast from NPR about public companies going private, and vice versa.)
8. To the company, equity represents sharing the ownership with outsider investors. These part-owners get a say, through annual shareholder meetings and occasional votes, in how the company is run. While going public can increase the amount of capital the original owners of a company have access to, they must (potentially) share any profits with those shareholders. But the company has no obligation to return the capital investors provide through issuing stock.
9. To shareholders, owning a share in a company exposes them to the both the potential to share in profits, and the chance of sharing in losses. In return for this exposure, shareholders get to vote at annual meetings and on occasional issues facing the management. Shareholders may also receive dividends, which is one form in which the company returns profits to the owners. Not all companies pay dividends.
10. Companies can also choose to buy back shares, which effectively returns value to shareholders who choose to tender their shares for repurchase. Check out the Sept 22, 2014 entry on Damodaran’s Blog about buybacks – it’s great!
Part II – Optimal Debt to Equity ratio
If a company (public or private) has two basic sources of capital, how should they use these sources efficiently? Debt is generally less costly than equity, mainly because it’s less risky. A company must promise investors higher dividends or higher capital gains in order to entice them to buy shares.
In the diagram below, the cost of equity is shown higher than the cost of debt. At the extreme left, there is no debt and the company is 100% equity. At the extreme right it’s all debt and no equity. The cost of debt rises as the share of financing from debt rises as lenders worry about the ability of the company to pay the interest on a regular basis.
The blue line, known as the weighted average cost of capital (WACC, or ACC in the diagram), is the effective cost of acquiring assets, and it dips just right of the middle. The exact shape and position depends on many company specific factors, but one conclusion is clear: a company should fund assets using a combination of debt and equity, usually with a little more debt than equity. In the diagram, the optimal Debt/Equity split is shown as DE*.
The debt-equity ratio (DE*) of the company in the diagram above is about 1.5, which is pretty much the average for US companies. But D/Es vary quite considerably. This Investopedia entry talks about the variation in these ratios across industries.
Part III – Advantages and disadvantages of Equity vs. Debt
Advantages to the company (by which I mean the original or current owners):
~Equity does not have to be paid back. There’s an expectation it will be, but no legal obligation to do so.
~Debt is a finite obligation. Once paid back, there’s no more burden on the company.
~Debt is cheaper due to lower risk.
~Debt servicing is tax deductible.
Disadvantages to the company:
~Equity holders (shareholders) can vote on issues affecting the management of the company, and may want things that the management does not.
~Selling shares dilutes the ownership of the company, letting “outsiders in.”
~If shares are sold to the public, the company must file reports with the SEC.
~Debt holders must be paid off before many other creditors if the company goes bankrupt or is liquidated.
~Interest on debt must be paid on a regular basis, and the principle paid back when due.
A major problem for companies is to find the balance between these many, sometimes competing, factors. There are number of alternative theories to explain the balance between debt and equity financing of capital.
Take the Quiz on the Learn website.
Aside: Leverage ratio
Sometimes the debt-equity ratio is called the leverage ratio. (Check out this Investopedia video on the Leverage Ratio.) The cost of obtaining loans increases as companies go further in debt. To lenders the existing equity is being increasingly leveraged, and becomes more at risk. At some point the increasing debt service costs, and the inability to find anyone who will lend money to them, will mean that a company almost never is 100% debt financed.
Additional Resources/links
1. Refer to this Wikpedia entry for Corporate Finance:
http://en.wikipedia.org/wiki/Corporate_finance
2. Investopedia video on the Leverage Ratio.
3. A pretty simple (simplistic?) video on Capital Structure from Khan Academy:
http://www.youtube.com/watch?v=YEZMReBbkP0
(This also demonstrates how lame Khan academy videos are…)
Homework
Write a one page, typed (single spacing is fine) essay on the following question:
The Miller and Modigliani Theorem (1958) states that under certain conditions, the capital structure a company chooses–the DE ratio–has no effect on the value of the company. (See this LINK.) Miller won the Nobel prize in Economics in part for this “irrelevance theorem.” What is the importance of the theorem today?
Discussion
Discuss this question:
1. When would you want to be a holder of a company’s debt (bondholder) and when would you want to be a part owner (shareholder?) Since debt and equity are traded in markets, both investors (demand) and companies (supply) have an influence on the relative price of debt and equity, and consequently on how companies are financed.
(These topics are only for the 16-week course)
2. Apple has been involved in one of the biggest share buyback programs in history (Read more here.) What does this mean for shareholders of Apple? Apple borrowed money to buy back shares rather than use any of the billions in cash it had–why?
3. While “going public” with an IPO is a big deal (Facebook, Twitter,…) some big public companies go private (Chrysler). Why would a public company choose to go private?
Philip Ganderton 