Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VI. Cost of Capital and

Long−Term Financial

Policy

17. Financial Leverage and
    Capital Structure Policy

© The McGraw−Hill^621

Companies, 2002

financial distress costs undoubtedly supplies part of the reason, but, to date, there is no

fully satisfactory theory that explains these regularities in capital structures.

A QUICK LOOK AT THE

BANKRUPTCY PROCESS

As we have discussed, one of the consequences of using debt is the possibility of finan-

cial distress, which can be defined in several ways:

CONCEPT QUESTIONS

17.8a Do U.S. corporations rely heavily on debt financing?

17.8bWhat regularities do we observe in capital structures?

594 PART SIX Cost of Capital and Long-Term Financial Policy

When it comesto capital structure, all companies (and industries)

are not created equal. To illustrate, we looked up some capital structure

information on Nissan Motor (NSANY) and Johnson & Johnson (JNJ) using

the “Ratio Comparison” area of yahoo.marketguide.com.Nissan’s capital

structure looks like this:

For every dollar of equity, Nissan has long-term debt of $1.78 and total debt of $3.20.

Compare this result to Johnson & Johnson:

For every dollar of equity, Johnson & Johnson has only $0.11 of long-term debt and

total debt of $0.15. When we examine the industry and sector averages, the differ-

ences are again apparent. The choice of capital structure is a management decision,

but clearly it is also influenced by industry characteristics.

Work the Web

Quick Ratio (MRQ)

Current Ratio (MRQ)

LT Debt to Equity (MRQ)

Total Debt to Equity (MRQ)

Interest Coverage (TTM)

0.64

0.95

1.78

3.20

1.12

Financial Strength Company

1.08

1.51

5.67

5.75

2.39

Industry

1.20

1.96

2.55

2.71

3.79

Sector

1.15

1.70

0.68

0.96

9.03

S&P 500

Quick Ratio (MRQ)

Current Ratio (MRQ)

LT Debt to Equity (MRQ)

Total Debt to Equity (MRQ)

Interest Coverage (TTM)

1.68

2.48

0.11

0.15

41.90

Financial Strength Company

1.13

1.66

0.38

0.56

30.87

Industry

2.54

3.18

0.41

0.54

18.34

Sector

1.15

1.70

0.68

0.96

9.03

S&P 500

17.9