Fundamentals of Financial Management (Concise 6th Edition)

De b t : R o c k e t B o o s t e r o r An c h o r?

(^13) Capital Structure and Leverage

CHAPTER

400

If it is to grow, a firm needs capital; and capital

comes primarily in the form of debt or equity.

Debt financing has two important advantages:

(1) The interest paid is tax deductible whereas

dividends paid on stock are not deductible,

which lowers debt’s relative cost. (2) The return

on debt is fixed, so stockholders do not have to

share the firm’s profits if the firm turns out to be

extremely successful.

However, debt also has disadvantages:

(1) Using more debt increases the firm’s risk, and

that raises the costs of debt and equity. (2) If the

company falls on hard times and its operating

income is not sufficient to cover interest charges,

the firm may go bankrupt. Good times may be just

around the corner, but too much debt can bank-

rupt the company before it reaches that corner.

Because of the risk of using debt, companies

with volatile earnings and operating cash flows

tend to limit its use. On the other hand, compa-

nies with relatively little business risk and stable

operating cash flows can benefit from taking on

more debt. Kellogg Co., the world’s largest cereal

manufacturer, is a good example of such a com-

pany. Indeed, just after its 2001 acquisition of

Keebler Foods Co., Kellogg’s book value capital

structure consisted of 86% debt and 14% equity.

An 86% debt ratio is quite high, and Kellogg’s

management was well aware that excessive

debt can push an otherwise well-regarded com-

pany into bankruptcy. Accordingly, Kellogg’s

management began to pay down its debt and

restore its balance sheet to a more “reasonable”

debt level so that by early 2008, its debt ratio had

fallen to around 70%.

For many companies, a 70% debt ratio would

still be too high. However, because Kellogg’s busi-

ness is so stable, this ratio is not too bad. After all,

the consumption of Frosted Flakes, Froot Loops,

and Pop Tarts has remained stable even during

economic downturns. Moreover, if we examine

Kellogg’s capital structure in more detail, it soon

becomes apparent that there is more than meets

the eye. According to its balance sheet, Kellogg

has about $5.86 billion of total debt versus stock-

holders’ equity of about $2.23 billion. But in

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