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CAPITAL STRUCTURE: THE

CHOICES AND THE TRADE OFF

“Neither a borrower nor a lender be”

Someone who obviously hated this part of corporate finance

3

First principles

5

Global PaSerns in Financing…

6

And a much greater dependence on bank loans

outside the US…

Stage 2

Rapid Expansion

Stage 1

Start-up

Stage 4

Mature Growth

Stage 5

Decline

Financing Choices across the life cycle

External

Financing

Revenues

Earnings

Owner’s Equity

Bank Debt

Venture Capital

Common Stock

Debt Retire debt

Repurchase stock

External funding

needs

High, but

constrained by

infrastructure

High, relative

to firm value.

Moderate, relative

to firm value.

Declining, as a

percent of firm

value

Internal financing

Low, as projects dry

up.

Common stock

Warrants

Convertibles

Stage 3

High Growth

Negative or

low

Negative or

low

Low, relative to

funding needs

High, relative to

funding needs

More than funding needs

Accessing private equity Inital Public offering Seasoned equity issue Bond issues Transitions

Growth stage

$ Revenues/

Earnings

Time

9

The TransiUonal Phases..

¨ The transiUons that we see at firms – from fully owned

private businesses to venture capital, from private to public

and subsequent seasoned offerings are all moUvated

primarily by the need for capital.

¨ In each transiUon, though, there are costs incurred by the

exisUng owners:

¤ When venture capitalists enter the firm, they will demand their fair

share and more of the ownership of the firm to provide equity.

¤ When a firm decides to go public, it has to trade off the greater access

to capital markets against the increased disclosure requirements (that

emanate from being publicly lists), loss of control and the transacUons

costs of going public.

¤ When making seasoned offerings, firms have to consider issuance

costs while managing their relaUons with equity research analysts and

rat

11

The Financing Mix QuesUon

¨ In deciding to raise financing for a business, is there

an opUmal mix of debt and equity?

¤ If yes, what is the trade off that lets us determine this

opUmal mix?

n What are the benefits of using debt instead of equity?

n What are the costs of using debt instead of equity?

¤ If not, why not?