ISBN: 0-03-028931-9

Chapter 14 Capital Structure and Leverage

Debt: Rocket Booster or Anchor?

When a firm expands, it needs capital, and that capital can come from debt or equity. Debt has two important advantages. First, interest paid is tax deductible, which lowers debt's effective cost. Second, debtholders get a fixed return, so stockholders do not have to share their profits if the business is extremely successful.
However, debt also has disadvantages. First, the higher the debt ratio, the riskier the company, hence the higher its cost of both debt and equity. Second, if a company falls on hard times and operating income is not sufficient to cover interest charges, its stockholders will have to make up the shortfall, and if they cannot, bankruptcy will result. Good times may be just around the corner, but too much debt can keep the company from getting there and thus can wipe out the stockholders
Companies with volatile earnings and operating cash flows therefore limit their use of debt. On the other hand, companies with less business risk and more stable operating cash flows can take on more debt. General Mills, a consumer-goods company with such well-known brands as Cheerios, Wheaties, Betty Crocker, and Hamburger Helper, is a good example of a stable company that uses a lot of debt financing. Indeed, General Mills' current capital structure as shown on its balance sheet is 90 percent debt and 10 percent equity.
At first glance, a 90 percent debt ratio seems extraordinarily high. In the past, there have been numerous examples of high debt pushing otherwise well-regarded companies into bankruptcy. For example, a few years ago, two of the nation's largest retailers, Federated Department Stores and R.H. Macy, were forced to declare bankruptcy as a result of their excessive use of debt.
Still, given the stability of its basic business, General Mills' high debt ratio might be appropriate. After all, the consumption of Cheerios and Hamburger Helper has historically remained stable even during economic downturns. Moreover, if we examine General Mills' capital structure in more detail, it soon becomes apparent that there is more here than first meets the eye. According to its year-end 1999 balance sheet, General Mills had roughly $2.5 billion of total debt versus only $164 million of stockholders' equity. However, the market value of General Mills' equity is actually much higher than its book value. At year-end 1999, the company's market capitalization of the equity (which is simply the stock price times the number of shares outstanding) was approximately $13 billion. From a market value perspective, General Mills' capital structure ($2.5 billion of debt versus $13 billion of equity) is thus quite conservative, and it also helps explain why General Mills has an A-level bond rating.
General Mills and other companies can finance with either debt or equity. Is one better than the other? If so, should firms be financed either with all debt or all equity? If the best solution is some mix of debt and equity, what is the optimal mix? In this chapter, we discuss the key facets of the debt-versus-equity, or capital structure, decision. As you read the chapter, think about these concepts and consider how they can aid mangers as they make capital structure decisions.

DISCUSSION QUESTIONS

1. As the level of debt has an effect on the risk of a firm, which kinds of companies would you expect to be willing to carry a substantial load of debt? Automobile companies? Computer companies? Telecommunications companies? Oil companies? Utilities companies?
2. Which measure of capital structure do you think is the most important, the book value capital structure or the market value capital structure?

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