DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is

DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is

referred to as its capital structure. The capital structure of a firm is some mix of debt, internally generated equity, and new equity. But what is the right mixture?

The best capital structure depends on several factors. If a firm finances its activities with debt, the creditors expect the amount of the interest and principal—fixed, legal commitments—to be paid back as promised. Failure to pay may result in legal actions by the creditors.

FINANCING DECISIONS

EXHIBIT 18.1 Financing the Firm

Suppose you borrow $100 and promise to repay the $100 plus $5 in one year. Consider what may happen when you invest the $100:

■ If you invest the $100 in a project that produces $120, you pay the lender the $105 you owe and keep the $15 profit. ■ If your project produces $105 back, you pay the lender $105 and keep nothing. ■ If your project produces $100, you pay the lender $105, with $5 com- ing out of your personal funds.

So if you reinvest the funds and get a return more than the $5 (the cost of the funds), you can keep all the profits. But if you get a return of $5 or less, the lender still gets her or his $5 back. This is the basic idea behind finan- cial leverage—the use of financing that has a fixed, but limited payments.

If the firm has abundant earnings, the owners reap all that remains of the earnings after the creditors have been paid. If earnings are low, the creditors still must be paid what they are due, leaving the owners nothing out of the earnings.

Failure to pay interest or principal as promised may result in finan- cial distress. Financial distress is the condition where a firm makes deci- sions under pressure to satisfy its legal obligations to its creditors. These decisions may not be in the best interests of the owners of the firm.

Capital Structure

With equity financing there is no obligation. Though the firm may choose to distribute funds to the owners in the form of cash dividends, there is no legal requirement to do so. Furthermore, interest paid on debt is deductible for tax purposes, whereas dividend payments are not tax deductible.

One measure of the extent debt is used to finance a firm is the debt ratio, the ratio of debt to equity:

Debt

Debt ratio = -----------------

(18-1)

Equity

The greater the debt ratio, the greater the use of debt for financing oper- ations, relative to equity financing.

Another measure is the debt-to-assets ratio, which is the extent to which the assets of the firm are financed with debt:

Debt

Debt-to-assets ratio = ---------------- (18-2)

Assets

There is a tendency for firms in some industries to use more debt than others. We see this looking at the capital structure for companies in different industries in Exhibit 18.2, where the proportion of assets financed with debt and equity are shown graphically. We can make some generalizations about differences in capital structures across industries:

■ Industries that are more reliant upon research and development for new products and technology—for example, pharmaceutical compa- nies—tend to have lower debt-to-asset ratios than firms without such research and development needs.

■ Industries that require a relatively heavy investment in fixed assets,

such as shoe manufacturers, tend to have lower debt-to-asset ratios. It is also interesting to see how debt ratios compare among indus-

tries. For example, the electric utility industry has a higher use of debt than the malt beverage industry. Yet within each industry there is varia- tion of debt ratios. For example, within the beverage industry, Cott Cor- poration, maker of retail-brand soft drinks, has a much higher portion of debt in its capital structure than, say, the Coca-Cola Company.

Why do some industries tend to have firms with higher debt ratios than other industries? By examining the role of financial leveraging, financial distress, and taxes, we can explain some of the variation in debt ratios among industries. And by analyzing these factors, we can explain how the firm’s value may be affected by its capital structure.

FINANCING DECISIONS

EXHIBIT 18.2 Proportions of Capital from Debt and Equity, 2001

Panel A: Beverage Industry

Panel B: Shoe Manufacturers

Panel C: Electric Utilities

Capital Structure

Exhibit 18.2 (Continued) Panel D: Pharmaceutical Companies

Source: Various company annual reports, 2001