![]() More important, it boosts the volatility of earnings and, by extension, of share price. It raises fixed interest expenses and thus shifts a company’s break-even point upward toward the expected sales level. But this enhancement of return on equity is not without cost. The Appeal of Debt Financingĭiscussion of this subject typically begins with an effort (like that in Exhibit II) to demonstrate debt’s favorable impact on a company’s return on equity. We also outline a process by which CFOs can arrive at a sensible debt policy, a policy that protects against short-term vagaries in the capital markets, enhances the company’s value (the total economic value of its debt and equity), recognizes its strategic position, and-not least important-can be understood by senior management. As a result, some of the assumptions of corporate financial policy are due for a careful rethinking. ![]() The major finding is that debt financing has in practice a far lower payoff than many CFOs believe. What is the CFO to do? Is such leveraging worth fighting over?īy way of answer, this article summarizes two decades of research on the use of debt by companies with equity-financing alternatives. Especially in companies for which equity financing is unacceptable and in which operating management-concerned primarily with production, sales, and marketing-is the dominant force, there is great pressure to leverage the company with an even greater percentage of debt. Continuation of inflation at a 10 % annual rate will drive up external financing needs and interest expenses as existing low-cost debt matures and must be refinanced at today’s high rates.ĬFOs, therefore, often find themselves in conflict with operating managers, who are eager to fund product-market strategies aimed at protecting competitive advantage. Nor is it apparent that these financial pressures will soon ease. Of a sample of 430 companies with a debt rating of A in 1972, 112 had been downgraded by 1981 and only 39 had received higher ratings. This deterioration has not gone unobserved. Address before the Conference Board’s 1981 Financial Outlook Conference. Worse, since much of that debt is short term, they also face volatile swings in interest rates and heightened refinancing risks.Įxhibit I Selected ratios of well-being for nonfinancial corporations average of year-end values Source: Henry Kaufman, “National Policies and the Deteriorating Balance Sheets of American Corporations” (New York: Salomon Brothers, February 25, 1981). Having piled so much new debt onto their balance sheets, they now face sharply higher interest payments as a percent of pre-tax profits. Hard-pressed during the 1970s to supply inflation-mandated additions to working capital and to meet the increased cost of new plant and equipment, CFOs leveraged every new dollar of equity with some 3½ dollars of debt. The overall deterioration in corporate financial health has been stunning (see Exhibit I). To assist companies in building an optimal capital structure, the authors outline a series of questions for CFOs to ask themselves before they establish a debt policy.Ī decade of high inflation has trapped many chief financial officers between severe financing needs and weakened balance sheets. So, too, do the hidden costs of higher leverage, which include the restrictions it places on a company’s flexibility in adapting financial policies to strategic goals. Corporate and personal tax rates, which of course vary from situation to situation, significantly affect the attractiveness of debt. Two decades of finance-based research, which the authors summarize here, qualify that wisdom substantially. It has been conventional wisdom that, whatever its troubling side effects, the aggressive use of financial leverage pays off in higher company values.
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