Chapter 13 Capital Structure and Leverage 425toward your chest—motivates you to drive more carefully; but you may get stabbed
if someone runs into you, even if you are being careful. The analogy applies to cor-
porations in the following sense: Higher debt forces managers to be more careful
with shareholders’ money; but even well-run! rms can face bankruptcy (get stabbed)
if some event beyond their control, such as a war, an earthquake, a strike, or a reces-
sion, occurs. To complete the analogy, the capital structure decision comes down to
deciding how big a dagger stockholders should use to keep managers in line.
If you! nd the discussion of capital structure theory imprecise and somewhat
confusing, you’re not alone. In truth, not even the chairman of the Federal Reserve
Board knows how to identify a! rm’s precise optimal capital structure or how to
measure the effects of capital structure changes on stock prices and the cost of capi-
tal. In practice, capital structure decisions must be made using a combination of
judgment and numerical analysis. Still, an understanding of the theoretical issues
presented here can help you make better judgments about capital structure issues.
SELF^ TEST Why does MM’s theory with taxes lead to 100% debt?
How would an increase in corporate taxes tend to a" ect an average! rm’s
capital structure? What about an increase in the personal tax rate?
Explain what asymmetric information means and how signals a" ect capital
structure decisions.
What is meant by reserve borrowing capacity, and why is it important to
! rms?
How can the use of debt serve to discipline managers?13-5 CHECKLIST FOR CAPITAL STRUCTURE DECISIONS
In addition to the types of analysis discussed previously,! rms generally consider
the following factors when making capital structure decisions:
- Sales stability. A! rm whose sales are relatively stable can safely take on more
debt and incur higher! xed charges than a company with unstable sales. Util-
ity companies, because of their stable demand, have historically been able to
use more! nancial leverage than industrial! rms. - Asset structure. Firms whose assets are suitable as security for loans tend to use
debt relatively heavily. General-purpose assets that can be used by many busi-
nesses make good collateral, whereas special-purpose assets do not. Thus, real
estate companies are usually highly leveraged, whereas companies involved
in technological research are not. - Operating leverage. Other things the same, a! rm with less operating leverage is
better able to employ! nancial leverage because it will have less business risk. - Growth rate. Other things the same, faster growing! rms must rely more heav-
ily on external capital. Further, the " otation cost involved in selling common
stock exceeds that incurred when selling debt, which encourages rapidly
growing! rms to rely more heavily on debt. At the same time, however, those
! rms often face higher uncertainty, which tends to reduce their willingness to
use debt. - Pro! tability. It is often observed that! rms with very high rates of return on
investment use relatively little debt. Although there is no theoretical justi! cation
for this fact, one practical explanation is that very pro! table! rms such as Intel,