Chapter 18 How Much Should a Corporation Borrow? 483
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In other words, financial slack is valuable. Having financial slack means having cash, mar-
ketable securities, readily salable real assets, and ready access to debt markets or to bank
financing. Ready access basically requires conservative financing so that potential lenders see
the company’s debt as a safe investment.
In the long run, a company’s value rests more on its capital investment and operating deci-
sions than on financing. Therefore, you want to make sure your firm has sufficient financial
slack so that financing is quickly available for good investments. Financial slack is most valu-
able to firms with plenty of positive-NPV growth opportunities. That is another reason why
growth companies usually aspire to conservative capital structures.
Of course financial slack is only valuable if you’re willing to use it. Take a look at the
nearby box, which describes how Ford used up all of its financial slack in one enormous
debt issue.
There is also a dark side to financial slack. Too much of it may encourage managers to take
it easy, expand their perks, or empire-build with cash that should be paid back to stockholders.
In other words, slack can make agency problems worse.
Michael Jensen has stressed the tendency of managers with ample free cash flow (or
unnecessary financial slack) to plow too much cash into mature businesses or ill-advised
acquisitions. “The problem,” Jensen says, “is how to motivate managers to disgorge
the cash rather than investing it below the cost of capital or wasting it in organizational
inefficiencies.”^34
If that’s the problem, then maybe debt is an answer. Scheduled interest and principal pay-
ments are contractual obligations of the firm. Debt forces the firm to pay out cash. Perhaps
the best debt level would leave just enough cash in the bank, after debt service, to finance all
positive-NPV projects, with not a penny left over.
We do not recommend this degree of fine-tuning, but the idea is valid and important. Debt
can discipline managers who are tempted to invest too much. It can also provide the pressure
to force improvements in operating efficiency. We pick up this theme again in Chapter 32.
Is There a Theory of Optimal Capital Structure?
No. That is, there is no one theory that can capture everything that drives thousands of corpo-
rations’ debt versus equity choices. Instead there are several theories, each more or less help-
ful, depending on each particular corporation’s assets, operations, and circumstances.
In other words, relax: Don’t waste time searching for a magic formula for the optimal debt
ratio. Remember too that most value comes from the left side of the balance sheet, that is,
from the firm’s operations, assets, and growth opportunities. Financing is less important. Of
course, financing can subtract value rapidly if you screw it up, but you won’t do that.
In practice, financing choices depend on the relative importance of the factors discussed
in this chapter. In some cases, reducing taxes will be the primary objective. Thus high debt
ratios are found in the lease-financing business (see Chapter 25). Long-term leases are often
tax-driven transactions. High debt ratios are also found in developed commercial real estate.
For example, modern downtown office buildings can be safe, cash-cow assets if the office
space is rented to creditworthy tenants. Bankruptcy costs are small, so it makes sense to lever
up and save taxes.
For smaller growth companies, interest tax shields are less important than preserving
financial slack. Profitable growth opportunities are valuable only if financing is available
when it comes time to invest. Costs of financial distress are high, so it’s no surprise that
growth companies try to use mostly equity financing.
(^34) M. C. Jensen, “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review 26 (May 1986),
pp. 323–329.
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Sealed Air’s
recapitalization
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Apple’s debt issue