The degree of operating leverage (DOL) is defined as the percentage change in EBIT resulting from a 1 percent change in sales.
a. The degree of operating leverage approaches a maximum as the firm comes closer to operating at its breakeven level of output.
b. All other things being equal, the higher a firm’s DOL, the greater is its business risk.
c. Business risk, the inherent variability of a firm’s EBIT, is also influenced by the variability of sales and operating costs over time.
The degree of financial leverage (DFL) is defined as the percentage change in earnings per share (EPS) resulting from a 1 percent change in EBIT.
The degree of financial leverage approaches a maximum as the firm comes closer to operating at its loss level, the level where EPS = $0.
All other things being equal, the higher a firm’s DFL, the greater is its financial risk.
Financial risk, the additional variability of a firm’s EPS that results from the use of financial leverage, can also be measured by various financial ratios, such as the debt -to total assets ratio and the times interest earned ratio.
The degree of combined leverage (DCL) is defined as the percentage change in earnings per share resulting from a 1 percent change in sales. It is also equal to the DOL for a company times that company’s DFL. The degree of combined leverage used by a firm is a measure of the overall variability of EPS due to the use of fixed operating and capital costs, as sales levels change.
EBIT-EPS analysis is an analytical technique that can be used to help determine the circumstances under which a firm should employ financial leverage.The indifference point in EBIT-EPS analysis is that level of EBIT where earnings per share are the same regardless of which of two alternative capital structures is used.
Cash insolvency analysis can be used to evaluate the impact of a proposed capital structure on the cash position of a firm during a major business downturn.
Other factors that are considered when establishing a capital structure policy are industry standards, profitability and need for funds, lender requirements, managerial risk aversion, and the desire of owners to retain control of the firm.
A Significant Deleveraging of AT&T’s Balance Sheet
As the result of $115 billion of investments in cable television systems, AT&T had accumulated $62 billion of debt prior to the announcement in October 2000 that it was breaking the business into four separate companies—AT&T Business Services (parent company), AT&T Consumer Services, AT&T Broadband, and AT&T Wireless. This debt included $33 billion that had shortterm maturities (less than one year), including $20 billion in commercial paper, which had to be refinanced every 30 to 90 days.
Investors and financial analysts were concerned about the effect of this level of debt on the riskiness of AT&T’s securities. Credit ratings, which reflect the riskiness of these securities, are important for a company, especially one with a large amount of debt, because they affect both the availability and cost of credit. In the case of commercial paper financing, many buyers of these securities only invest in companies with a top tier rating. If AT&T’s rating were to be cut by one of the ratings agencies (e.g., Moody’s or Standard & Poor’s), then the company might not be able to borrow any funds in the commercial paper market.
Also, if the credit ratings of AT&T’s long-term debts (bonds) were lowered, these securities would be less attractive to bond investors, and the company would have to pay higher interest rates on new issues of debt.
This would result in an increase in the company’s weighted average cost of capital and a decrease in the market value of the firm. In order to avoid the costs associated with an excessive reliance on debt financing, AT&T began a major deleveraging effort to eliminate as much as $25 billion in debt from its balance sheet. The primary method for accomplishing this goal was the sale of some of its non strategic assets, such as its multibillion-dollar investments in Time Warner Entertainment, various cable television companies, and international wireless assets. AT&T also planned to cut its common stock dividend, which could generate another $2.74 billion per year to help pay down debt.
By the end of 2004,AT&T’s long-term debt was expected to be reduced to about $10 billion, a further $3 billion reduction from the end of 2003.AT&T’s dividend was cut from $3.50/share in 2000 to $0.75/share in 2001. In 2004, the dividend rate was about $0.95/share. Value Line projects a year -end ratio of long-term debt to shareholders’ equity of 72.5 percent at the end of 2004 and 52.2 percent in 2008. This chapter focuses on the practical aspects of capital structure decisions, such as those faced by AT&T.
This chapter focuses on various tools of analysis that can assist managers in making capital structure decisions that will lead to a maximization of shareholder wealth. The following section develops techniques, derived from accounting data, for measuring operating and financial leverage. As discussed in the previous chapter, operating leverage and financial leverage are important components of a firm’s business risk and financial risk.
Other techniques, namely, EBIT -EPS analysis and cash insolvency analysis, can aid management in assessing the risk versus return trade-offs associated with the use of debt in a firm’s capital structure. The appendix to this chapter discusses breakeven analysis—an analytical tool that can provide insights into the business risk facing a firm.
Operating and Financial Leverage
The concepts of operating and financial leverage were introduced in the previous chapter. In finance, leverage is defined as a firm’s use of assets and liabilities having fixed costs in an attempt to increase potential returns to stockholders.
Specifically, operating leverage involves the use of assets having fixed costs, whereas financial leverage involves the use of liabilities(and preferred stock) having fixed costs. A firm uses operating and financial leverage in the hope of earning returns in excess of the fixed costs of its assets and liabilities, thereby increasing the returns to common stockholders.
Leverage is a double -edged sword, however, because it also increases the variability or risk of these returns. If, for example, a firm earns returns that are less than the fixed costs of its assets and liabilities, then the use of leverage can actually decrease the returns to common stockholders. Thus, leverage magnifies shareholders’ potential losses as well as potential gains. Leverage concepts are particularly revealing to the financial analyst in that they highlight the risk–return trade-offs of various types of financial decisions, such as those involving the capital structure of the firm.
Leverage and the Income Statement
Financial statements of the Allegan Manufacturing Company are referred to throughout this section for purposes of illustration. Table contains two types of statements for the firm—a traditional format and a revised format. The traditional format shows various categories of costs as separate entries. Operating costs include such items as the cost of sales and general, administrative, and selling expenses. Interest charges and preferred dividends, which represent capital costs, are listed separately, as are income taxes.
The revised format is more useful in leverage analysis because it divides the firm’s operating costs into two categories, fixed and variable.
Short -Run Costs Over the short run, certain operating costs within a firm vary directly with the level of sales whereas other costs remain constant, regardless of changes in the sales level. Costs that move in close relationship to changes in sales are called variable costs. They are tied to the number of units produced and sold by the firm, rather than to the passage of time. They include raw material and direct labor costs, as well as sales commissions.
Over the short run, certain other operating costs are independent of sales or output levels. These, termed fixed costs, are primarily related to the passage of time. Depreciation on property, plant, and equipment; rent; insurance; lighting and heating bills; property taxes; and the salaries of management are all usually considered fixed costs. If a firm expects to keep functioning, it must continue to pay these costs, regardless of the sales level. A third category, semivariable costs, can also be considered.
Semivariable costs are costs that increase in a stepwise manner as output is increased. One cost that sometimes behaves in a stepwise manner is management salaries.Whereas these costs are generally considered fixed, this assumption is not always valid. A firm faced with declining sales and profits during an economic downturn may often cut the size of its managerial staff.
Panels show the behavior of variable, fixed, and semivariable costs, respectively, over the firm’s output range. Not all costs can be classified as either completely fixed or variable; some have both fixed and variable components. Costs for utilities, such as water and electricity, frequently fall into this category.
Whereas part of a firm’s utility costs (such as electricity) is fixed and must be paid regardless of the level of sales or output, another part is variable in that it is tied directly to sales or production levels. In the revised format of Allegan’s income statement, these are divided into their fixed and variable components and are included in their respective categories of operating costs.
Traditional and Revised Income Statements, Allegan Manufacturing Company, Year Ending December 31, 2004
Note that in the revised income statement format, both interest charges and preferred dividends represent fixed capital costs. These costs are contractual in nature and thus are independent of a firm’s level of sales or earnings. Also note that income taxes represent a variable cost that is a function of earnings before taxes. Long-Run Costs Over the long run, all costs are variable. In time, a firm can change the size of its physical facilities and number of management personnel in response to changes in the level of sales. Fixed capital costs also can be changed in the long run.
Behavior of (a) Variable, (b) Fixed, and (c) Semivariable Costs
degree of operating leverage (DOL) degree of financial leverage (DFL)
Measurement of Operating and Financial Leverage
Fixed obligations allow a firm to magnify small changes into larger ones—just as a small push on one end of an actual lever results in a large “lift” at the other end. Operating leverage has fixed operating costs for its “fulcrum.”When a firm incurs fixed operating costs, a change in sales revenue is magnified into a relatively larger change in earnings before interest and taxes (EBIT). The multiplier effect resulting from the use of fixed operating costs is known as the degree of operating leverage (DOL).
Financial leverage has fixed capital costs for its “fulcrum.”When a firm incurs fixed capital costs, a change in EBIT is magnified into a larger change in earnings per share (EPS). The multiplier effect resulting from the use of fixed capital costs is known as the degree of financial leverage (DFL).
Degree of Operating Leverage A firm’s degree of operating leverage (DOL) is defined as the multiplier effect resulting from the firm’s use of fixed operating costs.More specifically, DOL can be computed as the percentagechange in earnings before interest and taxes (EBIT) resulting from a given percentage change in sales (output):
Percentage change in EBIT
DOL at X = ————————————
Percentage change in sales
Other Financial Risk Measures
In addition to using various financial ratios and the degree of combined leverage as measures of the financial risk facing a firm, it is possible to make more formal statements about the financial risk facing a company if the probability distribution of future operating income (EBIT) is approximately normal and the mean and standard deviation can be estimated. The number of standard deviations, z, that a particular value of EBIT is from the expected value, EBIT, can be computed using an expression similar to Equation:
where s is the standard deviation of EBIT. Equation , along with the probability values from Table V in the back of the book, can be used to compute the probability that EBIT will be less than (or greater than) some particular value.
For example, consider the case of the Travco Manufacturing Corporation. Given the current capital structure of Travco, the company has interest payment obligations of $500,000 for the coming year. The company has no preferred stock. The $500,000 in interest represents the loss level for Travco. If EBIT falls below $500,000, losses will be incurred (EPS will be negative). At EBIT levels above $500,000, Travco will have positive earnings per share.
Based upon past experience, Travco’s managers have estimated that the expected value of EBIT over the coming year is $700,000 with a standard deviation of $200,000 and that the distribution of operating income is approximately normal, as illustrated in Figure. With this information, it is possible to compute the probability of Travco having negative earnings per share over the coming year (or, conversely, the probability of having positive earnings per share).
Using Equation , the probability of Travco having negative EPS is equal to the probability of having EBIT below the loss level of $500,000, or
$500,000 – $700,000
z = —————————— = – 1.0
In other words, a level of EBIT of $500,000 is 1.0 standard deviation below the mean. From Table , it can be seen that the probability associated with a value that is less than or equal to 1.0 standard deviation below the mean is 15.87 percent. Thus, there is a 15.87 percent chance that Travco will have negative earnings per share (i.e., the shaded area in Figure) with its current capital structure. Conversely, there is an 84.13 percent chance (100 percent less 15.87 percent chance of losses) of having positive earnings per share.
This type of analysis can give a financial manager a better feel for the level of financial risk facing a firm. As we shall see later in the chapter, when a financial manager is considering two or more alternative capital structures, this same kind of analysis can be used to help select the most desirable capital structure.
An analytical technique called EBIT-EPS analysis can be used to help determine when debt financing is advantageous and when equity financing is advantageous.
Consider the Yuma Corporation with a present capital structure consisting only of common stock (35 million shares). Assume that Yuma is considering an expansion and evaluating two alternative financing plans. Plan 1, equity financing, would involve the sale of an additional 15 million shares of common stock at $20 each. Plan 2, debt financing, would involve the sale of $300 million of 10 percent long-term debt.
If the firm adopts Plan 1, it remains totally equity financed. If, however, the firm adopts Plan 2, it becomes partially debt financed. Because Plan 2 involves the use of financial leverage, this financing issue is basically one of whether it is in the best interests of the firm’s existing stockholders to employ financial leverage. Table illustrates the calculation of EPS at two different assumed levels of EBIT for both financing plans. Because the relationship between EBIT and EPS is linear, the two points calculated in Table can be used to graph the relationship for each financing plan, as shown in figure.
In this example, earnings per share at EBIT levels less than $100 million are higher using the equity financing alternative. Correspondingly, at EBIT levels greater than $100 million, earnings per share are higher with debt financing. The $100 million figure is called the EBIT-EPS indifference point. By definition, the earnings per share for the debt and equity financing alternatives are equal at the EBIT-EPS indifference point:
EPS (debt financing) = EPS (equity financing)
Probability Distribution of EBIT,Travco Manufacturing Company
where EBIT is earnings before interest and taxes; Id is the firm’s total interest payments if the debt alternative is chosen; Ie is the firm’s total interest payments if the equity alternative is chosen; and Nd and Ne represent the number of common shares outstanding for the debt and equity alternatives, respectively. The firm’s effective tax rate is indicated as T, and Dp is the amount of preferred dividends for the firm. This equation may be used to calculate directly the EBIT level at which earnings per share for the two alternatives are equal. The data from the example shown in Table yield the EBIT-EPS indifference point:
EBIT-EPS Analysis,Yuma Corporation (All Dollar Figures
Except Per-Share Amounts Are in Millions of Dollars)*
Note that in the equity financing alternative, a 66.67 percent increase in EBIT (from $75 million to $125 million) results in a 66.67 percent increase in earnings per share (from $0.90 to $1.50), or, by Equation , a degree of financial leverage of
DFL = ————
Similarly, in the debt financing alternative, a 66.67 percent increase in EBIT results in a 111.69 percent increase in earnings per share, or a degree of financial leverage of
DFL = ————
Figure EBIT-EPS Analysis,Yuma Corporation
A comparable magnification of earnings per share will occur if EBIT declines. This wider variation in earnings per share, which occurs with the debt financing alternative, is an illustration of financial risk, because financial risk is defined as the increased variability in earnings per share due to the firm’s use of debt. All other things being equal, an increase in the proportion of debt financing is said to increase the financial risk of the firm.
EBIT-EPS Analysis and Capital Structure Decisions
The tools of EBIT-EPS analysis and the theory of an optimal capital structure can help a firm choose an appropriate capital structure. This section uses an example to develop a 5- step procedure designed to assist financial managers in making capital structure decisions.
Balboa Department Stores has been 100 percent financed with equity funds since the firm was founded. While analyzing a major expansion program, the firm has decided to consider alternative capital structures. In particular, it has been suggested that the firm should use this expansion program as an opportunity to increase the long-term debt ratio from the current level of 0 percent to a new level of 30 percent. Interest on the proposed new debt will amount to $100,000 per year.
Step 1:Compute the expected level of EBIT after the expansion. Based on Balboa’s past operating experience and a projection of the impact of the expansion, it estimates its expected EBIT to be $500,000 per year under normal operating circumstances.
Step 2: Estimate the variability of this level of operating earnings. Based on the past performance of the company over several business cycles, the standard deviation of operating earnings is estimated to be $200,000 per year. (Operating earnings are assumed to be normally distributed, or at least approximately so.)
Step 3: Compute the indifference point between the two financing alternatives. This calculation will determine whether it is preferable to add new debt or to maintain the all -equity capital structure. Using the techniques of EBIT-EPS analysis previously discussed, the indifference point is computed to be $300,000.
Step 4: Analyze these estimates in the context of the risk the firm is willing to assume.
After considerable discussion, it has been decided that the firm is willing to accept a 25 percent chance that operating earnings in any year will be below the indifference point and a 5 percent chance that the firm will have to report a loss in any year. To complete this analysis, it is necessary to compute the probability that operating earnings will be below the indifference point, that is, the probability that EBIT will be less than $300,000. This is equivalent on the standard normal curve to the following:
$300,000 – $500,000
z = —————————
or 1.0 standard deviation below the mean. The probability that EBIT will be less than 1.0 standard deviation below the mean is 15.87 percent; this is determined from Table V at the end of the book. Therefore, on the basis of the indifference point criterion, the proposed new capital structure appears acceptable. The probability of incurring losses must now be analyzed. This is the probability that EBIT will be less than the required interest payments of $100,000. On the standard normal curve, this corresponds to the following:
$100,000 – $500,000
z = —————————
or 2.0 standard deviations below the mean. The probability that EBIT will be less than 2.0 standard deviations below the mean is 2.28 percent, as shown in Table V. According to this criterion, the proposed capital structure also seems acceptable.
If either or both of these tests had shown the proposed capital structure to have an unacceptable level of risk, the analysis would have been repeated for lower levels of debt than the proposed 30 percent rate. Similarly, because the proposed capital structure has exceeded the standards set by the firm, management might want to consider even higher levels of debt than the proposed 30 percent.
Step 5: Examine the market evidence to determine whether the proposed capital structure is too risky. This evaluation should be made in relation to the following: the firm’s level of business risk, industry norms for leverage ratios and coverage ratios, and the recommendations of the firm’s investment bankers.
This step is undertaken only after a proposed capital structure has met the “internal” tests for acceptability. Financial leverage is a double -edged sword: It enhances expected returns, but it also increases risk. If the increase in perceived risk is greater than the increase in expected returns, the firm’s weighted cost of capital may rise instead of fall, and the firm’s stock price and market value will decline.
It is important to note that a firm need not feel constrained by industry standards in setting its own capital structure. If, for example, a firm has traditionally been more profitable than the average firm in the industry, or if a firm’s operating income is more stable than the operating income of the average firm, a higher level of financial leverage can probably be tolerated. The final choice of a capital structure involves a careful analysis of expected future returns and risks relative to other firms in the industry.
EBIT-EPS Analysis and Stock Prices
An important question arising from EBIT-EPS analysis is the impact of financial leverage on the firm’s common stock price. Specifically, which financing alternative results in the higher stock price? Returning to the Yuma Corporation example discussed earlier, suppose the company is able to operate at the $125 million EBIT level. Then, if the company chooses the debt financing alternative, its EPS will equal $1.63, and if it chooses the equity alternative, its EPS will be $1.50.
But the stock price depends on the price–earnings (P/E) ratio that the stock market assigns to each alternative. Suppose the stock market assigns a P/E ratio of 16.0 to the company’s common stock if the equity alternative is chosen and a P/E ratio of 15.4 if the debt alternative is chosen. Recalling from Chapter that the P/E ratio (Equation) was defined as the market price per share of common stock (P0) divided by the current earnings per share (EPS), the common stock price can be calculated for both alternatives as follows:
These calculations show that in this case the stock market places a higher value on the company’s stock if the debt alternative is chosen rather than the equity alternative. Note that the stock market assigned a slightly lower P/E ratio to the debt alternative. The stock market recognized the increased financial risk associated with the debt alternative, but this increased risk was more than offset by the increased EPS possible with the use of debt.
To carry the Yuma Corporation example one important step further, suppose the company, while operating at the $125 million EBIT level, chooses an even higher level of debt in its capital structure significantly increases the company’s financial risk—to the point where bankruptcy could occur if EBIT levels turned downward in a recession. If the stock market assigns a P/E ratio of 10.0, for example, the stock price would be $22.50 (= $2.25 _ 10.0), and it would be clear that this change in capital structure is not desirable.
It is important to emphasize that the P/E ratios in the preceding example are simply assumptions. As an analytical technique, EBIT-EPS analysis does not provide a complete solution to the optimal capital structure question.
In summary, the firm potentially can show increased earnings to its stockholders by increasing its level of financial risk. However, because increases in risk tend to increase the cost of capital (which is analogous to a decrease in the P/E ratio), the firm’s management has to assess the trade -off between the higher earnings per share for its stockholders and the higher costs of capital.
Cash Insolvency Analysis
The times interest earned and fixed -charge coverage ratios were introduced. These ratios provide an indicator of the ability of a firm to meet its interest and other fixed charge obligations (including lease payments, sinking fund payments, and preferred dividends) out of current operating income. Also, in that chapter, liquidity ratios, such as the current ratio and the quick ratio, were introduced.
Liquidity ratios provide a simple measure of a firm’s ability to meet its obligations, especially in the near term. In that chapter, we also indicated that the best measure of a firm’s cash adequacy can be obtained by preparing a detailed cash budget.
Coverage ratios and liquidity ratios do not provide an adequate picture of a firm’s solvency position. A firm is said to be technically insolvent if it is unable to meet its current obligations. We need a more comprehensive measure of the ability of a firm to meet its obligations if this information is to be used to assist in capital structure planning.
This measure must consider both the cash on hand and the cash expected to be generated in the future. Donaldson has suggested that a firm’s level of fixed financial charges (including interest, preferred dividends, sinking fund obligations, and lease payments), and thus its debt -carrying capacity, should depend on the cash balances and net cash flows that can be expected to be available in a worst -case (recessionary environment) scenario. This analysis requires the preparation of a detailed cash budget under assumed recessionary conditions.
Donaldson defines a firm’s net cash balance in a recession, CBR, to be
CBR = CB0 + FCFR
where CB0 is the cash (and marketable securities) balance at the beginning of the recession, and FCFR is the free cash flows expected to be generated during the recession. Free cash flow represents the portion of a firm’s total cash flow available to service additional debt, to make dividend payments to common stockholders, and to invest in other projects. For example, suppose MINECO, a natural resource company, reported a cash (and marketable securities) balance of approximately $154 million. Suppose also that management anticipates free cash flows of $210 million during a projected 1-year recession.
These free cash flows reflect both operating cash flows during the recession and current required fixed financial charges. Under the current capital structure, consisting of approximately 32 percent debt, the cash balance at the end of the recession would be $364 million ($154 million plus $210 million). Assume that the management of MINECO is considering a change in its capital structure that would add an additional $280 million of annual after-tax interest and sinking fund payments (i.e., fixed financial charges). The effect would be a cash balance at the end of the recession of
CBR = $154 million + $210 million – $280 million = $84 million
The managers of MINECO must decide if this projected cash balance of $84 million leaves them enough of a cushion in a recession.
This analysis can be enhanced if it is possible to specify the probability distribution of expected free cash flows during a recession. For example, if the MINECO managers believe, based upon past experience, that free cash flows are approximately normally distributed with an expected value during a 1-year recession (FCFR) of $210 million and a standard deviation of $140 million, they can compute the probability of running out of cash if the new debt is added.
The probability of running out of cash is equal to the probability of ending the recession with a cash balance of less than $0. The probability distribution of MINECO’s cash balance [panel of will have the same shape (i.e., approximately normal with a standard deviation, s, of $140 million) as the probability distribution of free cash flows , except that it will be shifted to the left from a mean (FCFR) of $210 million to a mean (CBR) of $84 million [i.e., by the beginning cash balance ($154 million) plus expected free cash flows ($210 million) less additional fixed financial charges ($280 million)].
Employing an expression similar to Equation , where cash balance (CBR) is the variable of interest rather than EBIT, a cash balance of $0 is equivalent on the standard normal curve to the following:
($0 – $84 million)
z = ———————— = –0.60
From Table, the probability of a z value of –0.60 or less is 27.43 percent. Thus, with an additional $280 million in fixed financial charges, the probability of MINECO running out of cash during a 1-year recession is about 27 percent
The MINECO managers may feel that this is too much risk to assume. If they only want to assume a 5 percent risk of running out of cash during a 1-year recession, they can determine the amount of additional interest and sinking fund payments (i.e., fixed financial charges) that can be safely added. First, find the number of standard deviations (z) to the left of the mean that gives a 5 percent probability of occurrence in the lower tail of the distribution. From Table , this value of z is found to be approximately –1.65.Next, we calculate the expected cash balance (CBR) needed at the end of a 1-year recession if the risk of running out of cash is to be held to 5 percent:
($0 – CBR)
z = –1.65 = ———————
CBR = $231 million
Finally, since MINECO expects to enter the recession with $154 million in cash and to generate $210 million in free cash flow during a 1-year recession, it can take on just $133 million (i.e., $154 million + $210 million – $231 million) in additional fixed financial charges.
The willingness of management to assume the risk associated with running out of cash depends on several factors, including funds available from outstanding lines of credit with banks and the sale of new long-term debt, preferred stock, and common stock, and the potential funds realized by cutting back on expenses during a business downturn, reducing dividends, and selling assets.
Cash Flows and Cash Balance Probability Distributions, MINECO
Other Factors to Consider in Making Capital Structure Decisions
In addition to a consideration of tax effects, financial distress costs, agency costs, the business risk facing the firm, EBIT-EPS analysis, and cash insolvency analysis, there are additional factors normally considered as a firm makes its capital structure decisions. These factors are discussed briefly in this section.
Cash Balance Probability Distribution, MINECO
Financial analysts, investment bankers, bond rating agencies, common stock investors, and commercial bankers normally compare the financial risk for a firm, as measured by its interest and fixed -charge coverage ratios and its longterm debt ratio, with industry standards or norms. There is considerable evidence that the capital structure of an average firm varies significantly from industry to industry. The average industry debt ratio (i.e., long-term debt/equity) for the industries examined ranges from 2.02 for the auto and truck industry to 0.11 for computer software and services.
Firms tend to cluster around the industry average debt ratio, but there are major exceptions. For example, in the pharmaceutical industry, the debt ratio for Bristol- Myers Squibb is nearly four times the industry average of 0.23. A firm adopting a capital structure that differs significantly from the industry norms will have to convince the financial markets that its business risk is sufficiently different from the risk facing the average firm in the industry to warrant this divergent capital structure, without being penalized significantly in its market valuation.
Profitability and Need for Funds
As noted in the previous chapter, highly profitable firms, with limited needs for funds, tend to have lower debt ratios when compared with less profitable firms. Also, firms that undertake highly leveraged restructurings, such as AT&T’s use of debt to purchase television cable systems (discussed in the “FinanciaL Challenge” at the beginning of the chapter), may temporarily have debt ratios that are significantly above the optimal level until funds from asset sales, new equity issues, or operations can be generated to pay off the debtholders.
Lender and Bond -Rater Requirements
Lenders and bond -rating agencies often impose restrictions on a firm’s capital structure choices as a condition for extending credit or maintaining a bond or preferred stock rating. For example, Standard & Poor’s has established the benchmark standards shown in Table for rating the debt of electric utilities. These are not the only factors considered when establishing a company’s bond rating, but they are very important guidelines that a firm must follow if it wishes to retain or improve its credit rating. A more complete discussion of the factors considered by bond rating agencies is contained.
Long-Term Debt/Equity Ratios for Selected Industries for 2004
Managerial Risk Aversion
Management’s willingness to assume risk often has a major impact on the capital structure chosen by the firm, although the relative risk aversion of management does not influence the firm’s optimal capital structure. Some managers adopt unusually risky or unusually low -risk capital structures. When a suboptimal capital structure is chosen, the financial marketplace will normally penalize a firm for this action.
For example, because of an extremely conservative owner-management financing philosophy, Adolph Coors (the third largest U.S. brewer) did not have any long -term debt in its capital structure until 1990, when the company issued its first long -term debt securities. Even today, Coors’ long -term debt ratio is still well below the industry average. In 1990, most financial analysts agreed that Coors could safely add a significant amount of debt to its capital structure and thereby lower its overall cost of capital and increase the market value of the firm.
Coors has been able to sustain this capital structure because the Coors family controls 100 percent of the company’s voting shares. If this owner -management control did not exist, it is very likely that Coors would be acquired by new owners who would significantly modify the company’s capital structure. Differences in managerial philosophies regarding the appropriate capital structure for a firm are a major driving forc behind many leveraged buyout offers.
Nestlé is a huge, multinational Swiss foods corporation with operations in at least 150 countries. The overwhelming majority of its sales occur outside Switzerland. Nestlé’s various foreign operating subsidiaries enjoy considerable decentralized operational flexibility. Local division managers handle all marketing and production decisions.
In contrast to its decentralized operating policy, Nestlé uses a highly centralized financing strategy. All financing decisions are handled at corporate headquarters. The small corporate finance staff makes all funding decisions for the subsidiaries, establishes the firm’s worldwide consolidated capital structure, sets individual subsidiary capital structures, manages worldwide currency exposure risk, and mandates the dividend policy for subsidiaries.
When a subsidiary is first formed, about one -half of the needed financing —the funds used to acquire fixed assets —comes from equity contributions by the parent. The balance of the needed funds, primarily to support working capital investments, is acquired in the host country through the banking system or the sale of commercial paper. In some countries, where there is little or no risk of capital expropriation, the parent company may finance working capital needs, depending on the relative cost of funds for the parent compared to the local cost of funds for the subsidiary.
Each subsidiary normally pays a dividend of 100 percent of its profits back to the parent. This guarantees central control over the capital structure of each subsidiary. If additional funds are needed for investment, the parent provides them using the lowest -cost source of capital available. Nestlé manages its overall sources of capital with the objective of maintaining a top credit rating and thereby minimizing its capital costs. Why does Nestlé follow such a conservative financing strategy? Senior vice president of finance Daniel Regolatti states, “Our basic strategy is that we are an industrial company.
We have a lot of risks in a lot of countries, so we should not add high financial risks.” a This strategy recognizes the trade -offs between business risk and financial risk that have been discussed in this chapter.
Electric Utility Bond Rating Standards Retention of Control
Some firms use debt or preferred stock financing rather than common stock financing to avoid selling new shares of common stock. When new voting common stock is sold, the relative control position of existing stockholders is diluted.