Aswath Damodaran
1
The Debt-Equity Trade Off: The
Capital Structure Decision
Aswath Damodaran
Stern School of Business
Aswath Damodaran
2
First Principles
n
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.
n
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.
Aswath Damodaran
3
The Agenda
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?
Aswath Damodaran
4
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.
Aswath Damodaran
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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.
Aswath Damodaran
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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.
n
In general, this rate will be close to or equal to the rate at which the
company can borrow.
Aswath Damodaran
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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