Principles of Managerial Finance

522 PART 4 Long-Term Financial Decisions

The various types and characteristics of corporate bonds,a major source of

debt capital,were discussed in detail in Chapter 6. The cost of debt is lower than

the cost of other forms of financing. Lenders demand relatively lower returns

because they take the least risk of any long-term contributors of capital: (1) They

have a higher priority of claim against any earnings or assets available for pay-

ment. (2) They can exert far greater legal pressure against the company to make

payment than can holders of preferred or common stock. (3) The tax deductibil-

ity of interest payments lowers the debt cost to the firm substantially.

Unlike debt capital, which must be repaid at some future date,equity capital

is expected to remain in the firm for an indefinite period of time. The two basic

sources of equity capital are (1) preferred stock and (2) common stock equity,

which includes common stock and retained earnings. Common stock is typically

the most expensive form of equity, followed by retained earnings and then pre-

ferred stock. Our concern here is the relationship between debt and equity capital.

Key differences between these two types of capital, relative to voice in manage-

ment, claims on income and assets, maturity, and tax treatment, were summarized

in Chapter 7, Table 7.1. Because of its secondary position relative to debt, suppli-

ers of equity capital take greater risk than suppliers of debt capital and therefore

must be compensated with higher expected returns.

External Assessment of Capital Structure

We saw earlier thatfinancial leverageresults from the use of fixed-cost financing,

such as debt and preferred stock, to magnify return and risk. The amount of

leverage in the firm’s capital structure can affect its value by affecting return and

risk. Those outside the firm can make a rough assessment of capital structure by

using measures found in the firm’s financial statements. Some of these important

debt ratios were presented in Chapter 2. For example, a direct measure of the

degree of indebtedness is the debt ratio.The higher this ratio, the greater the rela-

tive amount of debt (or financial leverage) in the firm’s capital structure. Mea-

sures of the firm’s ability to meet contractual payments associated with debt

include the times interest earned ratioand the fixed-payment coverage ratio.

These ratios provide indirect information on financial leverage. Generally, the

smaller these ratios, the greater the firm’s financial leverage and the less able it is

to meet payments as they come due.

Balance Sheet

Long-term debt

Assets Stockholders’ equity

Preferred stock

Common stock equity

Common stock

Retained earnings

Current liabilities

Equity

capital

Debt

capital

Total

capital