Chapter 13 Capital Structure and Leverage 427to turn down promising ventures because funds are not available will reduce our
long-run pro! tability. For this reason, my primary goal as treasurer is to always
be in a position to raise the capital needed to support operations.
We also know that when times are good, we can raise capital with either
stocks or bonds, but when times are bad, suppliers of capital are much more
willing to make funds available if we give them a stronger position, and this
means debt. Further, when we sell a new issue of stock, this sends a negative
“signal” to investors, so stock sales by a mature company such as ours are not
desirable.
Putting all these thoughts together gives rise to the goal of maintaining! nan-
cial " exibility, which from an operational viewpoint means maintaining adequate
“reserve borrowing capacity.” Determining the “adequate” reserve is judgmental;
but it clearly depends on the! rm’s forecasted need for funds, predicted capital
market conditions, management’s con! dence in its forecasts, and the consequences
of a capital shortage.
SELF^ TEST How does sales stability a" ect the target capital structure?
How do the types of assets used a" ect a! rm’s capital structure?
How do taxes a" ect the target capital structure?
How do the attitudes of lenders and rating agencies a" ect capital structure?
How does the! rm’s internal condition a" ect its actual capital structure?
What is! nancial # exibility, and is it increased or decreased by a high debt
ratio?13-6 VARIATIONS IN CAPITAL STRUCTURES
As might be expected, wide variations in the use of! nancial leverage occur across
industries and among individual! rms in each industry. Table 13-4 illustrates dif-
ferences for selected industries; the ranking is in descending order of the common
equity ratio, as shown in Column 1.^23
Pharmaceutical and aerospace/defense companies use relatively little debt
because their industries tend to be cyclical, oriented toward research, or subject
to huge product liability suits. Utility companies, on the other hand, use debt
relatively heavily because their! xed assets make good security for mortgage
bonds and because their relatively stable sales make it safe to carry more than
average debt.
The times-interest-earned (TIE) ratio gives an indication of how vulnerable the
company is to! nancial distress. This ratio depends on three factors: (1) the per-
centage of debt, (2) the interest rate on the debt, and (3) the company’s pro! tability.
Generally, low-leveraged industries such as pharmaceuticals and aerospace/de-
fense have high coverage ratios, whereas industries such as utilities, which! nance
heavily with debt, have low coverages.
(^23) Information on capital structures and! nancial strength is available from a multitude of sources. We used the
MSN Money web site to develop Table 13-4; but published sources include The Value Line Investment Survey, Robert
Morris Association Annual Studies, and Dun & Bradstreet Key Business Ratios.