. 1
( 14 .)




In the last few chapters, we have examined the investment principle, and argued
that projects that earn a return greater than the minimum acceptable hurdle rate are good
projects. In coming up with the cost of capital, which we defined to be the minimum
acceptable hurdle rate, however, we used the existing mix of debt and equity used by the
In this chapter, we examine the choices that a firm has in terms of both debt and

equity and how these choices change over a firm™s life cycle. In particular, we look at
how the choices change as a firm goes from being a small, private business to a large
publicly traded corporation. We then evaluate the basic tradeoff between using debt
and equity by weighing the benefits of borrowing against its costs. We close the
chapter by examining when the costs of borrowing exactly offset its benefits, i.e, debt
becomes irrelevant, and the implications for corporate finance.

The Choices: Types of Financing
There are only two ways in which any business
Hybrid Security: This refers to any
can raise money - debt or equity. This may seem
security that shares some of the
simplistic, given the array of choices firms have in
characteristics of debt and some
terms of financing vehicles. We will begin this section characteristics of equity.
with a discussion of the characteristics of debt and
equity and then look at a range of financing vehicles available within each of these
categories. We will then examine of a range of securities that share some characteristics
with debt and some with equity and are therefore called hybrid securities.

The Continuum between Debt and Equity

While the distinction between debt and equity is often made in terms of bonds and
stocks, its roots lie in the nature of the cash flow claims of each type of financing. The
first distinction is that a debt claim entitles the holder to a contracted set of cash flows
(usually interest and principal payments), whereas an equity claim entitles the holder to

any residual cash flows left over after meeting all other promised claims. While this
remains the fundamental difference, other distinctions have arisen, partly as a result of
the tax code and partly as a consequence of legal developments.
The second distinction, which is a logical outgrowth of the nature of cash flow
claims (contractual versus residual), is that debt has a prior claim on both cash flows on a
period-to-period basis (for interest and principal payments) and on the assets of the firm
(in the case of liquidation). Thirdly, the tax laws have generally treated interest expenses,
which accrue to debt holders, very differently and often much more advantageously than
dividends or other cash flows that accrue to equity. In the United States, for instance,
interest expenses are tax deductible, and thus create tax savings, whereas dividend
payments have to be made out of after-tax cash flows. Fourth, debt usually has a fixed
maturity date, at which point the principal is due, while equity generally has an infinite
life. Finally, equity investors, by virtue of their claim on the residual cash flows of the
firm, are generally given the bulk of or all of the control of the management of the firm.
Debt investors, on the other hand, play a much more passive role in management,
exercising, at most, veto power1 over significant financial decisions. These differences
are summarized in figure 7.1.
Figure 7.1: Debt versus Equity

Fixed Claim Residual Claim
Tax Deductible Not Tax Deductible
High Priority in Financial Trouble Lowest Priority in Financial Trouble
Fixed Maturity Infinite
No Management Control Management Control

Debt Hybrid Securities Equity
Bank Debt Convertible Debt Owner™s Equity
Commercial Paper Preferred Stock Venture Capital
Corporate Bonds Option-linked Bonds Common Stock
To summarize, debt is defined as any financing vehicle that is a contractual claim
on the firm (and not a function of its operating performance), creates tax-deductible
payments, has a fixed life, and has a priority claim on cashflows in both operating periods
and in bankruptcy. Conversely, equity is defined as any financing vehicle that is a

residual claim on the firm, does not create a tax advantage from its payments, has an
infinite life, does not have priority in bankruptcy, and provides management control to
the owner. Any security that shares characteristics with both is a hybrid security.
In Practice: A Financing Checklist for Classifying Securities
Some new securities, at first sight, are difficult to categorize as either debt or
equity. To check where on the spectrum between straight debt and straight equity these
securities fall, answer the following questions:
1. Are the payments on the securities contractual or residual?
If contractual, it is closer to debt

If residual, it is closer to equity

2. Are the payments tax deductible?
If yes, it is closer to debt

If no, if is closer to equity

3. Do the cash flows on the security have a high priority or a low priority if the firm is in
financial trouble?
If it has high priority, it is closer to debt.

If it has low priority, it is closer to equity.

4. Does the security have a fixed life?
If yes, it is closer to debt

If no, it is closer to equity

5. Does the owner of the security get a share of the control of management of the firm?
If no, it is closer to debt.

If yes, if is closer to equity

7.1. ˜: Is this debt or is it equity?
You have been asked to classify a security as debt or equity, and have been provided the
following characteristics for the security - it requires fixed monthly payments that are tax
deductible and it has an infinite life. Its claims on the cash flows of the firm, during

1 The veto power is usually exercised through covenants in bond agreements.

operation, and on the assets, if the firm goes bankrupt, come after all debt holders™ claims
(including unsecured debt) are met.
a. It is debt
b. It is equity
c. It is a hybrid security

A. Equity
While most people think of equity in terms of common stock, the equity claim can
take a variety of forms, depending partly upon whether the firm is privately owned or
publicly traded, and partly upon the firm™s growth and risk characteristics. Private firms
have fewer choices available than do publicly traded firms, since they cannot issue
securities to raise equity. Consequently, they have to depend either upon the owner or a
private entity, usually a venture capitalist, to bring in the equity needed to keep the
business operating and expanding. Publicly traded firms have access to capital markets,
giving them a wider array of choices.

1. Owner™s Equity

Most businesses, including the most successful companies of our time, such as
Microsoft and Wal-Mart, started off as small businesses with one or a few individuals
providing the seed money and plowing back the earnings of the firm into the businesses.
These funds, brought in by the owners of the company, are referred to as the owner™s
equity, and provide the basis for the growth and eventual success of the business.

2. Venture Capital and Private Equity

As small businesses succeed and grow, they
typically run into is a funding constraint, where the Venture Capital: This is usually
equity capital provided to a private
funds that they have access to are insufficient to
firm by an investor or investors, in
cover their investment and growth needs. A venture
exchange for a share of the
capitalist or private equity investor provides equity ownership of the firm.
financing to small and often risky businesses in return
for a share of the ownership of the firm.

Generally speaking, the capacity to raise funds from alternative sources and/or to
go public will increase with the size of the firm and decrease with the uncertainty about
its future prospects. Thus, smaller and riskier businesses are more likely to seek venture
capital and are also more likely to be asked to give up a greater share of the value of the
firm when receiving the venture capital.

7.2. ˜: The Effects of Diversification on Venture Capitalist
You are comparing the required returns of two venture capitalists, who are interested in
investing in the same software firm. One venture capitalist has all of his capital invested
in only software firms, whereas the other venture capitalist has invested her capital in
small companies in a variety of businesses. Which of these two will have the higher
required rate of return?
a. The venture capitalist who is invested only in software companies
b. The venture capitalist who is invested in a variety of businesses
c. Cannot answer without more information

If both venture capitalists described above had the same expected cash flow estimates for
the business, which one would demand a larger share of the ownership for the same
capital investment?
a. The venture capitalist with the higher required rate of return
b. The venture capitalist with the lower required rate of return

3. Common Stock

The conventional way for a publicly traded firm to raise equity is to issue
common stock at a price the market is willing to pay. For a newly listed company, this
price is estimated by the issuing entity (such as an investment banker) and is called the
offering price. For an existing publicly traded company, the price at which additional
equity is issued is uaully based upon the current market price. In some cases, the common
stock issued by a company is uniform; that is, each share receives a proportional share of
both the cash flows (such as dividends) and the voting rights. In other cases, different
classes of common stock will provide different dividends and voting rights.

Common stock is a simple security, and it is relatively easy to understand and
value. In fact, it can be argued that common stock makes feasible all other security
choices for a publicly traded firm, since a firm without equity cannot issue debt or hybrid
securities. The accounting treatment of common stock follows well-established
precedent, and can be presented easily within the conventional format of financial

4. Warrants

In recent years, firms have started looking at equity alternatives to common stock.
One alternative used successfully by the Japanese companies in the late 1980s involved
warrants, where the holders received the right to buy shares in the company at a fixed
price in return for paying for the warrants up front.
Warrants: A warrant is a security
Since their value is derived from the price of the
issued by a company that provides the
underlying common stock, warrants have to be holder with the right to buy a share of
treated as another form of equity. stock in the company at a fixed price
Why might a firm use warrants rather than during the life of the warrant.
common stock to raise equity? We can think of several reasons. First, warrants are priced
based upon the implied volatility assigned to the underlying stock; the greater the
volatility, the greater the value. To the degree that the market overestimates how risky a
firm is, the firm may gain by using warrants and option-like securities. Second, warrants,
by themselves, create no financial obligations at the time of the issue. Consequently,
issuing warrants is a good way for a high growth firm to raise funds, especially when
current cash flows are low or negative. Third, for financial officers who are sensitive to
the dilution created by issuing common stock, warrants seem to provide the best of both
worlds ““ they do not create any new additional shares currently, while they raise equity
investment funds for current use.

7.3. ˜: Stock Price Variance and the use of Warrants
Companies with high variance in their stock prices should use warrants more than
companies with low variance in their stock prices, because warrant prices increase with

a. True
b. False

In Practice: Valuing Warrants
Warrants are long term call options, but standard option pricing models are based
upon the assumption that exercising an option does not affect the value of the underlying
asset. This may be true for listed options on stocks, but it is not true for warrants, since
their exercise increases the number of shares outstanding and brings in fresh cash into the
firm, both of which will affect the stock price. The expected negative impact (dilution) of
exercise will make warrants less valuable than otherwise similar call options. The
adjustment for dilution in the Black-Scholes to the stock price involves three steps:
Step 1: The stock price is adjusted for the expected dilution from warrant exercise.
Dilution-adjusted S = (S ns+W nw) / (ns + nw)
S = Current value of the stock nw = Number of warrants outstanding
W = Market value of warrants outstanding ns = Number of shares outstanding
When the warrants are exercised, the number of shares outstanding will increase,
reducing the stock price. The numerator reflects the market value of equity, including
both stocks and warrants outstanding. Making this adjustment will lower the stock price
used in the model and hence the value of the warrant.
Step 2: The variance used in the option pricing formula is the variance in the value of the
equity in the company (i.e., the value of stocks plus warrants, not just the stocks).

5. Contingent Value Rights

Contingent value rights provide investors with the right to sell stocks for a fixed
price, and thus derive their value from the volatility of the stock and the desire on the part
of investors to hedge away their losses. Put options, which are traded on the option
exchanges, give their holders a similar right to sell the underlying stock at a fixed price.
There are two primary differences between contingent value rights and puts. First, the

. 1
( 14 .)