Life Cycles of Companies...Mature Companies (Large Caps) Three

Life Cycles of Companies...Mature Companies (Large Caps) Three

Financial Restructuring

Two aspects of financing affect the cost of capital, and through it the value that we derive for a firm. First, we will look at how changes in the mix of debt and equity used to fund operations affect the cost of capital. Second, we will look at how the choices of financing (in terms of seniority, maturity, currency, and other features) may affect the cost of funding and value.

The trade-off between debt and equity is simple. Interest expenses are tax deductible and cash flows to equity are not, making debt more attractive, relative to equity, as marginal tax rates rise. Debt can also operate as a disciplinary mechanism on managers in mature firms; managers are less likely to make bad investments if they have to make interest payments each period. Debt on the other hand has its own disadvantages. The first is 'expected bankruptcy cost', since as debt increases, so does the probability of bankruptcy. One direct cost of bankruptcy is incurring legal fees and court costs, which can be exorbitant and eat away at the value of a firm. But worse still is the effect of being perceived as being in financial trouble: Customers may stop buying your products, suppliers may demand cash for goods, and employees may abandon ship, creating a downward spiral for the firm that may destroy it. 

Another disadvantage of debt is 'agency cost', arising from different and competing interests of equity investors and lenders in a firm.  Equity investors see more upside from risky investments than lenders do. As lenders become aware of this conflict of interest, they protect themselves by either writing covenants into loan agreements or charging higher interest rates. This trade off forces management to consider both the costs and benefits of taking on more debt.

The optimal financing mix is one that minimizes a company's cost of capital. The amount of a company's sustainable cash flow will help determine the optimal equity/debt balance of a firm. The more stable and predictable a company's cash flow and the greater the magnitude of these cash flows - as a percentage of enterprise value - the higher the company's optimal debt ratio can be. And because the main advantage of debt is the tax benefit, the higher the tax rate, the higher the debt ratio should be as well.

The senior management of a firm has to consider the above capital requirements of its firm and try to find the right balance to enhance long-term shareholder value. This only underlies the importance of a company's free cash flows (ability of a company to self-fund) and its return on invested capital (ability to create value over time).

to be continued...


Resources

The Little Book of Valuation

Aswath Damodaran