504 CHAPTER 13 Capital Structure Decisions
and Standard & Poor’s that its bonds would be downgraded if it issued more debt.
This influenced its decision to finance its expansion with common equity.
10.Market conditions.Conditions in the stock and bond markets undergo both
long- and short-run changes that can have an important bearing on a firm’s opti-
mal capital structure. For example, during a recent credit crunch, the junk bond
market dried up, and there was simply no market at a “reasonable” interest rate
for any new long-term bonds rated below triple B. Therefore, low-rated compa-
nies in need of capital were forced to go to the stock market or to the short-term
debt market, regardless of their target capital structures. When conditions eased,
however, these companies sold bonds to get their capital structures back on target.
11.The firm’s internal condition.A firm’s own internal condition can also have a
bearing on its target capital structure. For example, suppose a firm has just suc-
cessfully completed an R&D program, and it forecasts higher earnings in the
immediate future. However, the new earnings are not yet anticipated by investors,
hence are not reflected in the stock price. This company would not want to issue
stock—it would prefer to finance with debt until the higher earnings materialize
and are reflected in the stock price. Then it could sell an issue of common stock,
retire the debt, and return to its target capital structure. This point was discussed
earlier in connection with asymmetric information and signaling.
12.Financial flexibility.Firms with profitable investment opportunities need to be
able to fund them .An astute corporate treasurer made this statement to the authors:
Our company can earn a lot more money from good capital budgeting and operating
decisions than from good financing decisions. Indeed, we are not sure exactly how
financing decisions affect our stock price, but we know for sure that having to turn down
a promising venture because funds are not available will reduce our long-run
profitability. 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 secured 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 financial
flexibility,which, from an operational viewpoint, means maintaining adequate reserve
borrowing capacity.Determining an “adequate” reserve borrowing capacity is judgmen-
tal, but it clearly depends on the factors discussed in the chapter, including the
firm’s forecasted need for funds, predicted capital market conditions, management’s
confidence in its forecasts, and the consequences of a capital shortage.
How does sales stability affect the target capital structure?
How do the types of assets used affect a firm’s capital structure?
How do taxes affect the target capital structure?
How do lender and rating agency attitudes affect capital structure?
How does the firm’s internal condition affect its actual capital structure?
What is “financial flexibility,” and is it increased or decreased by a high debt ratio?
Summary
This chapter examined the effects of financial leverage on stock prices, earnings per
share, and the cost of capital. The key concepts covered are listed below:
500 Capital Structure Decisions
