Financing Decision: Higgins, BAB 6

Higgins, BAB 6
Financing Decision
Bayu Putradana
Di-zenah Rachma
Faisal Habibie
Yosep Erjuandi Silaban
OUTLINE
Measuring the Effects of
Leverage on a Business
Financial - Leverage and Risk
Leverage - Leverage and Earnings
How Much to Borrow

Selecting a Maturity - Irrelevance
Structure - Tax Benefits
Inflation and Financing Strategy - Distress Cost
- Flexibility
- Market Signaling
- Management Incentives
- The Financing Decision and
Growth
Financial Leverage
HOW TO RAISE
CAPITAL
Selecting Proper Financing Instrument
DECIDE HOW MUCH EXTERNAL DESIGN WHAT INSTRUMENT TO

CAPITAL IS REQUIRED BE SOLD
Financial Leverage
Seperti fungsi sebuah tongkat atau
“lever” dalam fisika, leverage
bertujuan untuk meningkatkan force
atau gaya.
Dalam bisnis lever yang digunakan

berupa Debt Financing yang
bertujuan untuk meningkatkan
expected return, namun resiko loss
yang ditanggung juga semakin besar
ROE = ROIC + (ROIC – i’) (D/E)
Financial Leverage
Financial Leverage
INCREASE OWNERS THE RISK ALSO

EXPECTED RETURN GETTING HIGHER
Illustration of Financial Leverage
Effect of Financial Leverage on ROE (Return on
Equity)
CONCLUSION FROM LEVERAGE GRAPH
1. A larger range of possible outcomes means greater uncertainty about what

ROE the company will earn.
2. And if the range is getting larger, the greater change of bankcruptcy will be
happened to the company.
Measuring the Effects of
Leverage on a Bussiness
Measuring the Effects of Leverage on a
Bussiness
Leverage & Risk
Leverage & Earning

2. Leverage & Earnings
“How the two financing schemes are likely to affect reported income and return on
equity” by looking at projected income statement.
+ Tax Advantages
Reduce tax as a subsidy from govn, to encourage the use of debt financing
- Reduces earning after tax,
Although debt financing reduces EAT, it also reduces shareholders investment

in the firm.
2. Leverage & Earnings
How Much to Borrow?
How Much to Borrow?
• What level of debt financing is best for a firm?
• M-M principle is that in the absence of taxes and transaction costs, the firm’s debt
levels does not impact value.
• Total cash flows generated over time are the basis for the firm’s value.
• The debt-equity split only determines how this value is apportioned between
holders of debt and holders of equity.
How Much to Borrow?
Real World Issues
• Taxes and transaction costs are part of he real world.
• What are the various items to take into consideration when making decisions
about financing with debt or equity?
Irrelevance
“When Cashflow are constant, the capital structure decision is irrelevant.”
1. Tax Benefits
• Interest is tax deductible.
• Lowering the tax bill leaves more left over for all investors, meaning the pool of
shareholders and debtholders.
2. Distress Cost
● Increased debt leads to higher expected costs associated with financial
distress.
● Bankruptcy costs debt can turn a mild inconvenience into a major problem
involving
– major legal expenses and/or
– the sale of company assets at fire sale prices

2. Distress Cost
1. Bankruptcy Cost
(probability bankruptcy will occur) x (costs incurred when bankrupt)
Bankruptcy does not necessarily imply to liquidation. (in US) Bankruptcy is a

highly uncertain process. Increased debt
1. Indirect Cost.
• Indirect costs come in many forms.
• Lost profit opportunities from cutbacks toR&D.
• Lost sales as customers bail, fearing difficulties down the line, or suppliers bail
out of fear that the firm won’t pay its bills.

2. Distress Cost
3. Conflicts of Cost
• When the times are rough, bankruptcy looks like it’s just around the corner, it
might bereasonable for a firm to try a Hail Mary pass.
• If the Hail Mary fails, debtholders will pick up the tab.
• If the Hail Mary works, equity holders benefit and bankruptcy is averted.
• See Table 6.7.
• This behavior was part of the S&L crisis in the 1980s.

3. Flexibility
If the existing debt level is below target, debt financing is the obvious choice. If
current debt level is above terget, time to issue equity.
• Credit squeezes happen.
• A firm might not be able to borrow to stay competitive, when it needs it most to
fund an important investment opportunity.
• For this reason, firm managers must think about being financial flexible.
• Cash is king, so finance while it’s possible, using equity if it’s available and not too
expensive.
4. Market Signaling
• When companies announce that they intend to raise new equity, their stock
prices drop.
• On average, the drop in value is about one third the size of the new issue.
• Announcements about new debt have a much more neutral impact.
• Announcements about stock repurchases result in a stock price increase.

4. Market Signaling
● Dilution
Does issuing new equity lower EPS?
● Rosy Outlook (see figure 6.2)
If the outlook is rosy, then relative to what they would be otherwise, increased
leverage
– raises g*
– increases EPS
4. Market Signaling
● Opportunistic issues
Managers might issue new equity when they view current equity as being
overpriced.
● Pecking Order
They use equity only as a last resort.

5. Management Incentives
● Being human, managers look out for #1 (themselves) before shareholders
(Agency problem).
● Their actions increase private value to them at the expense of shareholder
value.
● Aggressive debt financing can reducing gap of owner & manager interest
The Financing Decision : Rapid Growth
1. Rapid Growth & the Virtues of Conservatism
High growth and high debt are dangerous combination

Use prudent debt policies:
● Maintain conservative leverage ratio

● Adopt Modest dividend payout ratio
● If investment needs temporarily > funds generated by internal operations, draw
down cash and use debt as a backstop.
○ Do not issue debt if it jeopardizes financial flexibility.
○ Sell equity rather than jeopardize financial flexibility.
○ Reduce growth only as a last alternative
The Financing Decision : Low Growth
2. Low Growth & the Appeal of Aggressive Financing
● Easier time with financing decisions when excess operating cash flows.
● Financial flexibility & Market Signaling are not an issue.
● Use the company’s healthy operating CF as a magnet to borrow-> repurchase
shares.
● Benefit of debt :
+ Increased interest tax shields, if the company is profitable.
+ The share repurchase announcement will be warmly greeted by the market,
and the firm’s stock price will go up.
+ The higher debt will inject additional discipline in respect to management
incentives.
Selecting Maturity Structure
Selecting a Maturity Structure
• What is the right maturity for debt?
• The minimum risk maturity structure is to match the maturity of the liabilities
against the maturity of the operating income from the firm’s assets.
• This makes the liabilities self-liquidating.
• If the debt matures too soon, there is refinancing risk.
• If the debt matures too late, the company must manage the cash until maturity.
Selecting a Maturity Structure
Mismatch :
• Debt with the right maturity is unavailable.
• Mismatching will reduce total borrowing costs.
• Beware market timing in efficient markets

Inflation & Financing Strategy
• During inflationary times, debts get repaid with cheaper dollars.
• Investors who expect inflation ask for higher interest rates to compensate them
for the inflation they expect.
• Only if inflation is unexpected, is it true that debtors gain at the expense of
debtholders.
• The deflation story is the reverse.

APPENDIX : Irrelevant Preposition
“Holding expected CF constant, the way a company finances its operations has no effect
on a firm/shareholder value”
The irrelevance proposition is significant not because it describes reality, but

because it directs attention to what’s important about financing decisions:
understanding how financing choices affect firm cash flows.
Tabel 6A.1 :Income Statement with Taxes
and No Taxes
In the Absence of Taxes,
Debt Financing Affects
Neither Income nor Firm
Value; In the Presence of
Taxes, Prudent Debt
Financing Increases
Income and Firm Value
Thank You!

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Higgins, BAB 6

How Much to Borrow

DECIDE HOW MUCH EXTERNAL DESIGN WHAT INSTRUMENT TO

Dalam bisnis lever yang digunakan

INCREASE OWNERS THE RISK ALSO

1. A larger range of possible outcomes means greater uncertainty about what

Leverage & Risk

Leverage & Earning

- Reduces earning after tax,

Although debt financing reduces EAT, it also reduces shareholders investment

• Taxes and transaction costs are part of he real world.

– major legal expenses and/or

– the sale of company assets at fire sale prices

(probability bankruptcy will occur) x (costs incurred when bankrupt)

Bankruptcy does not necessarily imply to liquidation. (in US) Bankruptcy is a

• Indirect costs come in many forms.

• Lost profit opportunities from cutbacks toR&D.

out of fear that the firm won’t pay its bills.

• If the Hail Mary fails, debtholders will pick up the tab.

• See Table 6.7.

• This behavior was part of the S&L crisis in the 1980s.

• Credit squeezes happen.

• Announcements about new debt have a much more neutral impact.

• Announcements about stock repurchases result in a stock price increase.

Does issuing new equity lower EPS?

● Rosy Outlook (see figure 6.2)

They use equity only as a last resort.

High growth and high debt are dangerous combination

● Maintain conservative leverage ratio

• This makes the liabilities self-liquidating.

• If the debt matures too soon, there is refinancing risk.

• Debt with the right maturity is unavailable.

• Mismatching will reduce total borrowing costs.

• Beware market timing in efficient markets

for the inflation they expect.

• Only if inflation is unexpected, is it true that debtors gain at the expense of

• The deflation story is the reverse.

The irrelevance proposition is significant not because it describes reality, but

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