The second half of Chapter 12 discusses the use of debt financing in capital str
ID: 2704810 • Letter: T
Question
The second half of Chapter 12 discusses the use of debt financing in capital structure. The book refers to this practice as leverage, because the use of debt magnifies the the EPS (earnings per share) that results from any level of EBIT (earnings before interest expense and taxes), both in the positive direction as well as in the negative direction. We know that some industries, such as utilities that provide us with electricity and natural gas, insurance companies, and supermarket chains all have consistently higher levels of debt in their capital structure (leverage) than the average US company. We also know that by comparison, corporations in Europe and Japan have a higher proportion of debt in their capital structure than their US counterparts.
Discuss reasons why these types of companies have capital structure policies that call for relatively high levels of debt in their capital structures. Also describe reasons that would cause their managements to alter the mix of debt and equity in the capital structure, in response to managerial, market, and general economic conditions.
Explanation / Answer
Its called the "pecking order hypothesis". Debt is considered as a cheaper source of finance as compared to equity. furthermore, issuing more equity shares causes a dilution in the ownership of the existing share holders. Further, when a company decides to raise capital through equity, the market gets a general feeling that perhaps the company is overvalued /hyped and this causes its share price to fall & loosening of investor confidence. On the other hand when a company raises debt, shareholders get a feeling that perhaps the company is expecting good future and that's why they are willing to raise capital through a more riskier alternative (debt is riskier than equity). Additionaly, the sectors you named are extremely capital intensive involving huge fixed costs which requires frequent funds. Raising equity frequently is cumbersome and damagin for a company's reputation in the market.