Capital Financing with Debt: Intro to Corporate Finance | Part 4

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We can look at the use of debt from two different lenses the first is from the corporation’s point of view and they use debt for two reasons one is to lower their costs of capital and the other is to avoid equity dilution so that’s from the point of view of the person that is raising money and using the debt for their operation of their business the other lens that

We can look at it through is from an investor’s perspective an investor may use debt to increase their equity return so they have to put down as little equity as possible and fund the rest with debt so let’s take a closer look at what we mean with some examples here is a graph of a firm’s weighted average cost of capital on the turquoise line at point a it’s funded

Exclusively with equity at point b it’s funded mostly with debt and you can see that the cost of capital is high both those points but the sweet spot in the middle is where it uses the optimal amount of debt to lower that cost of capital all else being equal an investment with a lower cost of capital will have a higher net present value so it creates value for the

Corporation now from an investor’s point of view if they were a private equity firm who was gonna buy a company and they could fund it as you can see here with some equity and some debts and then they were to invest for five years and value of the company were to grow but they were to pay down the debt you can see that when we look into the future the equity return

Is much greater than the return for the overall company because the debt was repaid the equity piece grows disproportionately so the equity rate of return is higher so that’s why an investor would borrow money just as you would to use a mortgage on your home private equity firms use debt to increase their equity returns assessing debt capacity once we know why

It makes sense for a company to take on some debt we have to figure out how much debt it makes sense for the company to take on so we can look at some general measures such as the company’s profitability ebody earnings before interest taxes depreciation and amortization is one of the most commonly used metrics lenders will also look at the company’s volatility

Of ebay da to see how stable the business is it will also look at the company’s capital expenditure requirements any cyclicality risk in the industry and the level of competition among many many other things to assess the overall attractiveness of lending to this company lenders can also look at balance sheet measures such as the company’s debt to equity ratio

Debt to total capital ratio debt to assets and other balance sheet ratios this is just giving you a quick flavor of how lenders might look at a business and then moving on from the balance sheet they can look at the cash flow measures such as the company’s total debt to ebody senior debt to ebody net debt to ebay de cash interest coverage and ebay de – capex /

Interest which is the interest coverage ratio there are many more ratios that we cover in our financial analysis fundamentals course and other financial modeling courses but as you can see there are quite a few ratios and quite a bit of analysis that can be done to figure out how much debt capacity a company has at the end of the day it’s a balancing act lenders

Want to make sure that they’re going to be repaid the capital that they’ve lent to the business the business also wants to make sure that it can repay the capital but it does want to try to maximize generally speaking the amount of debt that it can handle and so it’s a balancing of all of these measures to figure out the right amount let’s take a closer look

At the senior debt section of a company’s overall capital stack you can see here the components of senior debt it could include things like a revolving line of credit facility from a bank also called a revolver and then a series of term loans term loans have a fixed schedule where they repay or are amortized and have a final principal repayment and they could be

Stacked in terms of term loan a b c and so on in terms of the capacity for senior debt typically banks and other lenders will provide two to three times a cup ebit uh they may require two times interest coverage to satisfy their requirements and you can typically find senior debt at commercial banks credit companies and insurance companies senior debt ranks first

So it’s always going to be paid out before any other lenders and well before equity senior debt may or may not come with guarantees from the business and its owners now let’s take a look at the middle of the capital stack where we have subordinated debt as you can see here there are various types of subordinated debt or sub debt that sit between senior debt and

Equity as would be whole capital stack you’ve got increasing subordination as you move down which means you also have an increasing return profile and increasing risk as you move from top to bottom so you can look at the subordinated debt section in that lens but from a company’s perspective you have increasing dilution in terms of your equity ownership as you

Move down as well issuing common shares is the most elusive to equity investors but some of these subordinated debt instruments do carry convertible options that could result in some dilution so let’s walk down the list starting at the top we have high-yield bonds also sometimes referred to as junk bonds subordinated to junk bonds is mezzanine financing or meds

For short and mezzanine financing can come with warrants attached or without warrants attached warrants would convert into shares of the company and therefore cause equity dilution and that’s why you can see the dotted line between warrantless and warranted mezzanine debt payment in kind notes or pic notes have interest that accrues and is not paid out until the

End in one large payment and finally a vendor note is put in place when the owner of a business is selling to a private equity firm and they are going to receive part of their payout for selling the firm later in the future so it is a form of debt that the company has to repay to that who sold their position later we’d encourage you to do more research onto each

Of these types of subordinated debts as may be appropriate for you but being an introductory course we just want you to understand conceptually how they fit into the capital stack and how firms and investors think about where everything fits together in a company’s financing strategy a company’s cost of debt is directly related to how risky it is and in order to

Assess how risky a company’s debt profile is there are debt rating agencies that will rate companies and you can see here in this table we’ve provided examples from moody’s s&p fitch and db rs of their ratings for companies and there is a bright line on this table right in the middle here that we’ve highlighted that separates two categories in the top you have

What’s called investment grade investment grade is deemed safe for institutional investors with lower risk and lower return below that line there is what’s termed high-yield and sometimes also called junk bonds where there’s higher risk higher return and more fees associated with a raising debt so it’s very important to understand as both a company that’s going

To be raising money or an investor that’s going to be investing in bonds where you fit on this spectrum because it’s going to be directly related to the cost of debt let’s take a closer look at mezzanine debt mezzanine debt is non traded unlike a bond which is traded and it’s subordinated to the senior debt of a company is typically repaid as a bullet which means

It’s not amortized that means all of the principal is repaid at the end it typically has a combination of cash and accrued interest built into its return meaning part of the interest is paid out with actual cash and part of it is accrued and not paid out until the end with the bullet payment it can also have equity warrants attached which means it’s convertible

Into some equity upside so it gets an additional rate of return that means there’s also a dilution for the company if it’s converted into stock let’s take a look at the return profile for mezzanine debt first there’s the cash pay interest that’s the interest has actually paid out with cash then there’s the accrued interest that builds and is paid out at the end

That’s the contractual return between the company and the investor above that there could be warrants anywhere from three to ten percent of the sale of a company at the exit value and all of that would combine then to give the mezzanine investors a targeted internal rate of return somewhere between 14 and 20 percent just as an example so if you think of the full

Capital stack with equity investors at the bottom targeting 20 to 30 percent internal rates of return or higher then you’ve got the mezzanine investors at 14 to 20 percent and of course below them you have other debt investors that are in safer positions with lower rates of return say below 10 percent irr s let’s take a look at debt repayment profiles so you can

Understand from a cash flow perspective how this debt gets paid off let’s start with senior debt tranche a which is an example of equal amortize alone’s equal amortize it means that principal is repaid in equal amounts all the way until the end of the loan value when there’s no principal left to be repaid then we have senior debt tranche b which is an example of a

Balloon payment this type of debt has some amortization payments along the way of principal which is why you can see the turquoise line going down but then at the end there’s a balloon payment that’s left to be repaid next you have mezzanine finance and high-yield debt with what’s called a bullet payment at the end a bullet payment is the whole amount you can see

That the gold line does not decline as it moves across horizontally that’s because none of the principal is being repaid until the end it’s just the interest that’s being paid along the way and then finally the last line is payment in kind or pik which has a bullet payment at the end but you can see that this orange is actually increasing over time that’s because

The interest is not actually being paid out and hence the term payment in kind its accruing and adding to the balance of principle that’s owed at the end so you can see that there’s a bullet payment at the end that’s larger than the amount that the company started with in our financial modeling courses that follow in the fmv a curriculum will be modeling a company’s

Debt schedule and it will be very important to keep these different debt repayment profiles in mind let’s look at the pros and cons of issuing equity and using equity capital and then let’s look at the pros and cons of issuing debt and using debt capital when it comes to equity one of the main benefits is that there’s no interest payments or mandatory fixed payments

That are required so it saves cash flow for the business there’s also no maturity date or ultimate return of capital unless the entire company is sold or liquidated it comes with ownership rights and control over the business typically this is expressed through voting rights it also has a high implied cost of capital so yes there’s ownership but it is more expensive

And it also expects a high rate of return which is a combination of dividends and capital appreciation for the investors it has the last claim on a firm’s assets if it’s sold which means it’s the riskiest it provides the most operational flexibility for a management team because there are no ongoing fixed payments or interest payments associated with it now let’s

Look on the debt side of things debt typically comes with interest payments it has a fixed schedule so it is more of a drain on cash flow for a business the investors have the first claim of the company’s assets if it’s sold or liquidated so it’s safer for them it typically comes with covenants from the lenders though that require specific financial performance

Metrics to be met so it’s restricting in terms of operational flexibility it has a lower cost though than equity which is one of its biggest advantages the investors expect a lower rate of return than the equity investors because they’re in a safer position it prevents dilution to equity investors if a company needs more money and it borrows money that saves it

Issuing shares which is dilutive to the equity holders however the trade-off of all that is that it can push a company into default and bankruptcy and raise its cost of capital along the way so as you can see there are many pros and cons to both equity and debt and it’s up to the managers of a business to find the optimal balance between the two when funding their operations

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Capital Financing with Debt: Intro to Corporate Finance | Part 4 By Corporate Finance InstituteliveBroadcastDetails{isLiveNowfalsestartTimestamp2020-03-11T170012+0000endTimestamp2020-03-11T171607+0000}