The Debt-Equity Trade Off: The
Capital Structure Decision
Stern School of Business
Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.
• The hurdle rate should be higher for riskier projects and reflect the
financing mix used - owners’ funds (equity) or borrowed money (debt)
• Returns on projects should be measured based on cash flows generated
and the timing of these cash flows; they should also consider both positive
and negative side effects of these projects.
n Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
If there are not enough investments that earn the hurdle rate, return the
cash to stockholders.
The form of returns - dividends and stock buybacks - will depend upon
the stockholders’ characteristics.
n What is debt?
n What determines the optimal mix of debt and equity for a company?
n How does altering the mix of debt and equity affect investment
analysis and value at a company?
n What is the right kind of debt for a company?
What is debt...
n 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.
What would you include in debt?
n Any interest-bearing liability, whether short term or long term.
n Any lease obligation, whether operating or capital.
Converting Operating Leases to Debt
n The “debt value” of operating leases is the present value of the lease
payments, at a rate that reflects their risk.
In general, this rate will be close to or equal to the rate at which the
company can borrow.
Operating Leases at The Gap
n Operating lease expenses in 1995 = $304.6 million
n Cost of Debt in 1995 = 7.30%
n Duration of Le