How To Choose a Capital Structure: Navigating the Debt‐Equity Decision

In corporate offices as well as the classroom, there continues to be significant debate about the costs and benefits of debt financing. There is also considerable variation in corporate credit ratings, even among companies as large and successful as those that make up the S&P 500. Many companies have been reassessing how they manage their balance sheet and their rating agency relationships; and with the market's generally favorable response to recapitalizations and dividend increases, such financing issues are likely to receive even more attention. Underlying the diversity of corporate credit ratings is widespread disagreement about the “right” credit rating—a matter that is complicated by the fact that the cost of debt varies widely among companies with the same rating. Although credit ratings are clearly tied to measures of indebtedness such as leverage and coverage ratios, the most important factor in most industries is a company's size. For many mid‐sized companies, an investment‐grade rating can be attained only by making a large, equity‐financed acquisition—or by making minimal use of debt. In this sense, the corporate choice of credit rating can be as much a strategic issue as a financial decision. Maintaining the right amount of financial fl exibility is a key consideration when determining the right credit rating for a given company (although what management views as value‐preserving flexibility may be viewed by the market as value‐reducing financial “slack”). A BBB rating will accommodate considerably more leverage (30–60%) in companies with fairly stable cash flows and limited investment requirements than in more cyclical or growth‐oriented companies (10–20%). When contemplating taking on more leverage, companies should examine all major operating risks and view their capital structure in the context of an enterprisewide risk management framework.