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Think about a company as an entity that invests in projects with the goal of maximizing the time-adjusted return. The company must fund those projects with eith

Think about a company as an entity that invests in projects with the goal of maximizing the time-adjusted return. The company must fund those projects with either debt or equity, and each funding source has a cost. The optimal debt load is one such that the projects undertaken by the company are funded at the lowest cost.

pixelmonkey 6y ago
This is a nice theoretical answer, but I am looking for something a little more practical. Also, assume that a company has already acquired all its "expensive capital" via venture markets and sale of private shares. Given the current metrics of the business, how should it decide how much "cheap capital" to acquire via the debt markets?
- formercoder 6y ago
  It’s perhaps a high level answer but it’s not theoretical, if you are interested in diving deep I would highly recommend Professor Damodaran’s corporate finance course, he is the gold standard and it’s available for free on YouTube. Without repeating the entire course I’ll try and expand. The critical business metric is free cash flow, all operational data leads to that. We can project the firms free cash flows out over a period of years. Now the question is: how much should we spend to get this stream of cash? It’s not simply less than the sum of the cash flows, because the ones that come later are worth less than the ones that come sooner. To account for this, we “discount” those cash flows at a specific rate, the weighted average cost of capital. This number is where we bring in the mix of debt and equity in the firm and contains the cost of equity financing and the cost of debt financing, which mostly has to do with what interest rate the firm can borrow at. There is an optimal quantity of debt that minimizes this discount factor, thus maximizing the value of the future cash flows, it’s convex. If we can spend less than those summed discounted cash flows, funded with that optimal mix of debt and equity, we are NPV positive. This means we are generating real economic profits with our business activities.
  - pixelmonkey 6y ago
    Super helpful. Thank you for this thoughtful answer and I'll check out the YouTube recommendation. Cheers!
  - pixelmonkey 6y ago
    I just want to thank you again for that YouTube recommendation for Prof. Damodaran’s course. It is exactly what I am looking for. In particular, the middle part of his course (“the financing decision”) is specifically about how to think about debt vs equity mix. https://twitter.com/amontalenti/status/1282735518061600768 https://twitter.com/amontalenti/status/1282735518061600768
    - formercoder 6y ago
      Enjoy! I hope you find corporate finance as cool as I do. He’ll cover this but keep in mind there are a few differences with a firm such as yours who’s investors are less diversified.
- sokoloff 6y ago
  Why would a company take on expensive capital if cheaper capital is readily available?
  - formercoder 6y ago
    If the cheaper capital is cheaper because it’s more restrictive.

pixelmonkey 6y ago

This is a nice theoretical answer, but I am looking for something a little more practical. Also, assume that a company has already acquired all its "expensive capital" via venture markets and sale of private shares. Given the current metrics of the business, how should it decide how much "cheap capital" to acquire via the debt markets?

formercoder 6y ago
It’s perhaps a high level answer but it’s not theoretical, if you are interested in diving deep I would highly recommend Professor Damodaran’s corporate finance course, he is the gold standard and it’s available for free on YouTube. Without repeating the entire course I’ll try and expand. The critical business metric is free cash flow, all operational data leads to that. We can project the firms free cash flows out over a period of years. Now the question is: how much should we spend to get this stream of cash? It’s not simply less than the sum of the cash flows, because the ones that come later are worth less than the ones that come sooner. To account for this, we “discount” those cash flows at a specific rate, the weighted average cost of capital. This number is where we bring in the mix of debt and equity in the firm and contains the cost of equity financing and the cost of debt financing, which mostly has to do with what interest rate the firm can borrow at. There is an optimal quantity of debt that minimizes this discount factor, thus maximizing the value of the future cash flows, it’s convex. If we can spend less than those summed discounted cash flows, funded with that optimal mix of debt and equity, we are NPV positive. This means we are generating real economic profits with our business activities.
- pixelmonkey 6y ago
  Super helpful. Thank you for this thoughtful answer and I'll check out the YouTube recommendation. Cheers!
- pixelmonkey 6y ago
  I just want to thank you again for that YouTube recommendation for Prof. Damodaran’s course. It is exactly what I am looking for. In particular, the middle part of his course (“the financing decision”) is specifically about how to think about debt vs equity mix. https://twitter.com/amontalenti/status/1282735518061600768 https://twitter.com/amontalenti/status/1282735518061600768
  - formercoder 6y ago
    Enjoy! I hope you find corporate finance as cool as I do. He’ll cover this but keep in mind there are a few differences with a firm such as yours who’s investors are less diversified.
sokoloff 6y ago
Why would a company take on expensive capital if cheaper capital is readily available?
- formercoder 6y ago
  If the cheaper capital is cheaper because it’s more restrictive.