Finding the Right Financing Mix: The Capital Structure Decision

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“Neither a borrower nor a lender be” someone who obviously hated this part of corporate finance

First Principles

Invest in projects that yield a return greater than the minimum acceptable hurdle rate.

  • The hurdle rate should be higher for riskier projects and reflect the financing mix used – owners’ funds (equity) or borrowed money (debt)
  • Returns on projects should be measured based on cash flows generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

If there are not enough investments that earn the hurdle rate, return the cash to stockholders.

  • The form of returns – dividends and stock buybacks – will depend upon the stockholders’ characteristics.
  • Objective: Maximize the Value of the Firm

The Choices in Financing

There are only two ways in which a business can make money.

  • The first is debt. The essence of debt is that you promise to make fixed payments in the future (interest payments and repaying principal). If you fail to make those payments, you lose control of your business.
  • The other is equity. With equity, you do get whatever cash flows are left over after you have made debt payments.

The equity can take different forms:

  • For very small businesses: it can be owners investing their savings • For slightly larger businesses: it can be venture capital
  • For publicly traded firms: it is common stock

The debt can also take different forms

  • For private businesses: it is usually bank loans
  • For publicly traded firms: it can take the form of bonds