Other Factors to Consider in Making Capital Structure Decisions - Financial Management

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

Industry Standards

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 Industriesfor 2004

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

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.

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