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Let's talk about obtaining long-term financing, owner investment, long-term loans, that permanent financing that is the backbone of any company's financing. Now, let's look at the issues associated with this and what we're gonna get to is this: Does it matter how I structure that? Does it matter how much owner-investment I have; how many loans I have? Does it impact the value of my company? Let's illustrate this with an example of Lily's Ice Cream Company, a hypothetical example. Lily has a dream. She wants to start and operate her own ice cream business and she's figured out that it's gonna cost $200 million to make that happen. In other words, $200 million to turn her dreams into reality, 'cuz she's gonna need to buy land and buildings and lots of ice cream machines. The question is where's Lily gonna get this $200 million? Where's she gonna obtain this long-term financing? Let's make some simplified assumptions here in this example, just to keep it tractable. The short-term financing issues, where's she gonna get the money to buy the strawberries and the cream? No bananas, by the way, in this ice cream company; strawberries and cream and sugar and those other natural ingredients. Where's she gonna get the money for those? Well, let's just assume it's gonna come from local bank financing, small, short-term loans and from the suppliers themselves. Let's leave short-term financing out of this. We're just looking at the long-term financing to buy the big stuff, the land and the buildings. Lily's capital structure is defined as the mix between owner investment and long-term borrowing. Where's she gonna get this $200 million in long-term financing? Well, there's gonna be mix. Some of its gonna come from owner investments, some of its gonna come from long-term borrowing. The question we're gonna address is: does it make any difference? Does Lily even care how much she gets from borrowing and how much she gets from long-term investment? That's the capital structure question. Does capital structure impact the value of the company and really, in the area of corporate finance, this is the question: Does capital structure impact value? To talk about this, we need to do a little historical discussion. The first sophisticated analysis of this was done in 1958, by Professors Modigliani and Miller. They said, "No. "No, it doesn't make any difference whether "you borrow the money or whether it's ownerinvested. "That does not impact the value of the company "so don't worry about capital structure." Now, they made some extreme assumptions. They said, "Listen, there are no taxes. "There are no bankruptcy costs. "There's no government. "There are none of these frictions that impact businesses "so we're talking about a perfect economy "where everybody can do whatever they want "with no restrictions whatsoever." In a case like that it doesn't matter whether you borrow the money or the company borrows the money or whether the owners borrow it themselves and then invest it in the company. It doesn't have any impact on the value of the company. It's a baseline result, the Modigliani-Miller theorem. They won Nobel prizes for this so this is a very powerful result, but it's in a sterile world where there are no frictions, no transactions costs. Let's think about the world. There are frictions. There are transactions costs and the first transaction cost that we can imagine is income taxes. The second view of capital structure and whether it impacts the value of a company is, well, in the case of income taxes, yeah, there is an impact on the value of the company. Because if I borrow money, then any payments I make to the people who provided the capital of the company, who loaned money to the company, is called interest-expense. Okay, fine. I don't care what you call it. Yeah, you do care what you call it, because interest-expense is now reported on my tax form as a tax deduction, so I pay less in taxes. If those same people had given me the money as an investment, and then any money I paid to them was called "dividends," I don't get a tax deduction for dividends. Providers of capital, if we call it a loan, then the payments to those providers of capital are called interest-expense, that's tax deductible. It lowers the amount of income tax that the company pays. Same people, if we call it an ownerinvestment, the payments made to the them are called dividends. Those are not tax deductible. In that case, that would suggest that there should never be any owner investment. Whenever a company wants to get money, they should borrow the money because then all payments are tax deductible and that will lower the amount of income taxes paid by the company. Well, those are the two extremes. Doesn't make any difference or you should borrow all the money. The third choice is kind of a middle ground. Yeah, there are forces pushing both ways. There are reasons to borrow money. There are reasons to have lower borrowing. There's a middle way. We already saw this with the example of the home mortgage. Does a home mortgage impact the value of your company? Well, there are forces in both directions. A high mortgage means you get a very high tax deduction so that would suggest let's have a high mortgage. But, a high mortgage puts me at risk of losing my house if I can't make the payments, so I don't wanna go to one extreme or the other. The answer is, yes, there are forces pushing in both ways. Capital structure does matter so I wanna make sure I get this right. What are those forces? There are benefits to borrowing. We've already talked about the tax benefit, but there are other benefits to borrowing, and this one might not seem like a benefit to you, if you're an employee in a company, but one benefit is if a company has high borrowing, that means they have to make high interest payments and they have to make those. There's no flexibility. If they don't make those interest payments, they're subject to the law. We all have to focus on making those interest payments. That means we can't be a very loose company. We can't have a lot of slack. We've gotta make sure we make those payments. When the labor union comes and says, "Listen, "we want higher wages." Well, we'd like to give you higher wages, but we can't 'cuz we borrowed all this money and we've gotta make sure that we can make the interest payments. Companies with higher borrowing have been shown to have less employee slack, less slack in the business. Things are run more tightly. Maybe not a pleasant situation to be in as an employee, but it does increase the value of the company from the standpoints of the owners. Now, you don't wanna borrow too much, because there are some costs to borrowing. The more a company borrows, the more chance the company will suffer bankruptcy proceedings. And, just like going through a bankruptcy associated with your house, it's a costly situation. A company going through bankruptcy proceedings is a very costly situation. First of all, with all due respect to you attorneys, more legal feeds, more money paid out of the company to attorneys as legal fees. Management is distracted. You're not thinking of long-term marketing plans when you're going through bankruptcy proceedings. Everybody starts arguing with one another as a company enters into bankruptcy. Bankruptcy's a very costly condition to be in. If I borrow more money, there's more chance that I will enter that costly condition. So, that's a reason to have lower borrowing. Is there an optimal capital structure? Yes, there is. I should have some borrowing, 'cuz there are tax benefits associated with it, but not too much because that increases the chances of financial distress. So, what is the optimal capital structure? Well, it's gonna depend on the specific business circumstances. For example, let's do a little thought experiment here. If tax rates are high, income tax rates are high, should a company have more borrowing in its capital structure, or less? Let's think this through. If tax rates are high that means I get a bigger tax deduction for interest. If I get a bigger tax deduction for interest, then I wanna borrow more. So, in a situation where tax rates are high, companies would tend to have more borrowing in their capital structure. What about the quality of the collateral associated with loans? If a company has very good collateral associated with loans, then they're more likely to borrow more. For example, if I'm borrowing the money to pay the wages of employees, that's not very good collateral. But, if I'm borrowing the money to build a building, that's good collateral. Banks are more willing to loan in a case like that. What about the stability of the cash flows of the business? If you have a company that's very stable, predictable cash flows, a company like that is able to borrow more. It doesn't make the lender so nervous. Uncertain cash flow, a company like that is able to borrow less. Let's look at two examples, two of your favorite companies and mine, Walmart and Google. They have very different capital structures. Let's do a thought experiment. Let's say that you and I had $20 billion and Walmart and Google both came to us and said, "We'd like to borrow that $20 billion dollars," and we need to decide to whom we should loan the $20 billion. We're gonna loan $20 billion to Walmart. If you loan $20 billion to Walmart, what are they probably gonna do with that money? Well, they're gonna use it to buy land. They're gonna use it to buy buildings. They're gonna use it to buy trucks, tangible things. Now, let's imagine a catastrophe scenario, Walmart can't pay us back. Something happens, something goes wrong with Walmart's business model. We loan them $20 billion and now they can't pay us back. All is not lost because the law is with us. If Walmart can't pay us back the $20 billion that we lent them, then we can go claim those buildings. We can go claim that land. We can go claim those trucks and recover a lot of the $20 billion. So we're willing to loan Walmart a little bit more money because they're assets provide good collateral for loans. We see that in Walmart's capital structure. Only 40% of Walmart's financing has been provided by owners. That means 60% has been provided in the form of loans. Lenders are willing to loan money to Walmart because, even in the worst case scenario, if Walmart can't pay us back, we go get the land. We go get the buildings. How about Google? You loan $20 billion to Google, something goes very wrong and Google can't pay you back. What do you do? You're in a tough situation because if you loan $20 billion to Google, what did they probably do with the money? They use it to pay their employee's salaries. They use it to pay for research and development. They bought some servers and server farms. That's what they used the $20 billion with. That's not very good collateral. What am I gonna do? Google can't pay me back, I'm gonna go door-to-door to the homes of their employees and say, "Listen, Google used some of the $20 billion "that I lent them to pay you. "I need the money back." That doesn't work. Go to the research and development staff; you can't get the money back. Go to those server farms, maybe you can sell those items for pennies on the dollar, but they don't serve as very good collateral. As a result, Google has received most of its long-term financing from investor-investment, 79%. Meaning only 21% has been borrowed in the form of loans, because Google's assets don't serve as very good collateral. Is there an optimal capital structure? Yeah, there is, and it's gonna differ depending on the circumstances of a company. What are the tax rates the company faces? What is the quality of the collateral that the company has? The optimal capital structure means we're not gonna borrow zero and we're not gonna borrow 100%. We're gonna borrow somewhere in between and it's gonna be a balancing of all these forces