The Debt/equity tradeoff

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The Debt/equity tradeoff

• Aswath Damodaran

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The trade off on debt versus equity
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The trade off at your firm

• Considering, for your firm,
• The potential tax benefits of borrowing
• The benefits of using debt as a disciplinary
  mechanism
• The potential for expected bankruptcy costs
• The potential for agency costs
• The need for financial flexibility
• Would you expect your firm to have a high debt
  ratio or a low debt ratio?
• Does the firms current debt ratio meet your
  expectations?

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Lets start with potential tax benefits

• Marginal tax rate Start with the marginal tax
  rate of the country in which the company is
  domiciled. If, as is common, the company gets the
  largest share of its income from the domestic
  market, the higher the marginal tax rate, the
  more debt you should have.
• Effective tax rate While it is true that debt
  saves you taxes at the margin, it is also true
  that the lower the effective tax rate, the more
  likely it is that the company has already found
  other ways to shelter itself from taxes and needs
  debt less.

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Belgium 33.99
Germany 29.48
Portugal 25
Italy 31.4
Luxembourg 28.8
Austria 25
Denmark 25
France 33.3
Finland 24.5
Greece 20
Iceland 20
Ireland 12.5
Netherlands 25
Norway 28
Slovenia 18
Spain 30
Sweden 26.3
Switzerland 21.2
Turkey 20
UK 24
W.Europe 22.6
Albania 10
Armenia 20
Belarus 18
Bosnia Herzegovina 10
Bulgaria 10
Croatia 20
Czech Republic 19
Estonia 21
Georgia 0
Hungary 19
Kazakhstan 20
Latvia 15
Lithuania 15
Montenegro 9
Poland 19
Romania 16
Russia 20
Slovakia 19
Slovenia 18
Ukraine 21
E. Europe Russia 20.5
Marginal tax rates In 2012
Bangladesh 27.5
Cambodia 20
China 25
Fiji Islands 28
Hong Kong 16.5
India 32.5
Indonesia 25
Japan 38
Korea 24.2
Malaysia 25
Pakistan 35
Papua New Guinea 30
Philippines 30
Singapore 17
Sri Lanka 28
Taiwan 17
Thailand 23
Vietnam 25
Asia 22.9
Bahamas 0.00
Bermuda 0.00
Bonaire 0.00
Cayman Islands 0.00
Georgia 0.00
Guernsey 0.00
Isle of Man 0.00
Jersey 0.00
Canada 26
USA 40
N. America 33
Argentina 35
Bolivia 25
Brazil 34
Chile 18.5
Colombia 33
Costa Rica 30
Ecuador 23
El Salvador 30
Guatemala 31
Honduras 35
Mexico 30
Panama 25
Paraguay 10
Peru 30
Uruguay 25
Venezuela 34
Latin America 28.3
Angola 35
Botswana 22
Egypt 25
Kenya 30
Mauritius 15
Namibia 34
Nigeria 30
South Africa 34.6
Tunisia 30
Zambia 35
Africa 29
Bahrain 0
Israel 25
Jordan 14
Kuwait 15
Libya 20
Oman 12
Qatar 10
Saudi Arabia 20
Middle East 14
Australia 30
New Zealand 28
Australia NZ 29
Black Total ERP Red Country risk
premium AVG GDP weighted average
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Effective tax rates across sectors US in 2013
Industry name Tax rate Industry name Tax rate Industry name Tax rate Industry name Tax rate
Advertising 32.82 Electrical Equipment 25.00 Machinery 28.47 R.E.I.T. 6.75
Aerospace/Defense 30.74 Electronics 22.26 Maritime 17.65 Railroad 31.78
Air Transport 31.82 Engineering Const 38.23 Med Supp Invasive 29.81 Recreation 30.40
Apparel 33.28 Entertainment 27.43 Med Supp Non-Invasive 27.13 Reinsurance 14.88
Auto Parts 30.29 Entertainment Tech 20.67 Medical Services 34.76 Restaurant 27.82
Automotive 17.11 Environmental 26.91 Metal Fabricating 34.47 Retail (Hardlines) 32.79
Bank 24.92 Financial Svcs. (Div.) 31.17 Metals Mining (Div.) 32.14 Retail (Softlines) 34.66
Bank (Midwest) 24.78 Food Processing 32.51 Natural Gas (Div.) 28.85 Retail Automotive 34.57
Beverage 32.52 Foreign Electronics 37.69 Natural Gas Utility 36.69 Retail Building Supply 39.97
Biotechnology 20.48 Funeral Services 32.15 Newspaper 27.30 Retail Store 35.25
Building Materials 26.15 Furn/Home Furnishings 25.84 Office Equip/Supplies 31.59 Retail/Wholesale Food 34.37
Cable TV 37.23 Healthcare Information 38.51 Oil/Gas Distribution 25.78 Securities Brokerage 44.89
Chemical (Basic) 25.68 Heavy Truck Equip 23.97 Oilfield Svcs/Equip. 25.81 Semiconductor 21.72
Chemical (Diversified) 26.32 Homebuilding 35.07 Packaging Container 27.51 Semiconductor Equip 15.91
Chemical (Specialty) 26.64 Hotel/Gaming 31.30 Paper/Forest Products 17.71 Shoe 31.23
Coal 17.27 Household Products 30.67 Petroleum (Integrated) 35.29 Steel 33.30
Computer Software 25.35 Human Resources 37.10 Petroleum (Producing) 24.60 Telecom. Equipment 28.32
Computers/Peripherals 23.26 Industrial Services 37.37 Pharmacy Services 31.87 Telecom. Services 30.64
Diversified Co. 28.09 Information Services 27.31 Pipeline MLPs 11.79 Telecom. Utility 38.10
Drug 18.67 Insurance (Life) 28.84 Power 33.64 Thrift 27.52
E-Commerce 27.19 Insurance (Prop/Cas.) 20.89 Precious Metals 30.29 Tobacco 37.16
Educational Services 32.70 Internet 29.30 Precision Instrument 24.56 Toiletries/Cosmetics 31.90
Electric Util. (Central) 32.00 Investment Companies 20.06 Property Management 34.40 Trucking 36.73
Electric Utility (East) 33.57 IT Services 23.93 Public/Private Equity 23.29 Water Utility 34.63
Electric Utility (West) 30.05 Machinery 28.47 Publishing 39.57 Wireless Networking 28.11
Total Market 28.37
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Added Discipline

• Past Project Choice Companies that have
  generated poor returns on their investments in
  the past, measured using return on capital and/or
  return on equity are better candidates.
• Past stock price performance Companies whose
  stocks have under performed the market (Jensens
  alpha) are better candidates.
• Insider holdings Companies where the top
  managers hold less stock are better candidates.
• Activist presence If an activist or activists
  are among the top holders, there is less need for
  debt.

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Expected Bankruptcy CostI. The Probability of
Bankruptcy

• Quantitative measures
• Level of operating earnings Companies with
  higher cashflow available to service debt should
  be able to borrow more.
• Variance in earnings Companies that operate in
  businesses where earnings are more volatile face
  a higher probability of bankruptcy.
• Dependence on one or a few customers A firm that
  is dependent on one or a few customers is more
  exposed.
• Qualitative measures
• Possibility of catastrophic risk If there is a
  possibility of a catastrophic risk, it is best to
  hold back on debt.
• Competition All else held constant, the more
  competitive the business, the more risk you face
  in earnings.
• Product type Products that change quickly or
  have short life cycles expose you to more
  bankruptcy risk.

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II. The Cost of Bankruptcy

• Direct costs If a companys assets are liquid
  and easily marketable, it should face less direct
  cost in liquidation than if its assets are
  illiquid, unique or have few buyers.
• Indirect costs The more damage that can be done
  to both revenues and operations by the perception
  that you are in trouble, the greater the indirect
  bankruptcy cost.

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Agency CostsThink like a lender!

1. Type of assets The more easily you can observe
   the assets that your lending is used to acquire,
   the more comfortable you feel lending money to a
   firm. Companies with more physical, fixed assets
   should have higher debt ratios than companies
   with intangible assets.
2. Monitoring The more easily you can monitor how a
   firm invests and spends its money, the more
   comfortable you feel about lending money.
3. History The more good history a firm has in
   borrowing money and returning the money, the more
   comfortable you feel lending your money.

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Loss of flexibilityFuture financing needs

• Amount of future financing needs A firm that has
  less future financing needs should be able to
  borrow more money than one that has more.
• Predictability of future financing needs A firm
  that has more volatility in its financing needs
  will borrow less than one that has a predictable
  financing need.