Among the various considerations that a board should consider in determining the appropriate balance between debt and equity in a company’s capital structure are the following:
Business Risk If the nature of a firm’s business results in a revenue stream that is inherently volatile and, because of the nature of the business, the firm is burdened with high fixed operating expenses, e.g., airlines, the addition of incremental debt to the firm’s capital structure should be more carefully considered.
Tax Position If a substantial portion of a firm’s income is already sheltered from taxes through accelerated depreciation or tax loss carry-forwards, the tax shield afforded by debt financing will not be as advantageous as it would be to a firm with a higher effective tax rate.
Financial Flexibility Does the company have the ability to raise capital on reasonable terms under adverse conditions?
Managerial Competence Does management have a successful track record in operating through severely adverse market conditions?
Concentration Is a large portion of the company’s business subject to concentration risk in terms of customers, geography or seasonality?
Industry leverage Is the company operating with a level of leverage that materially exceeds that of its industry competitors?
Life cycle Is the company still growing or has it achieved a maturity where free cash flow is predictable and stable?
Competition Does the company enjoy a defensible niche in its industry or face intense competition from larger, better-capitalized companies?
Richard De Rose is managing director of Houlihan Lokey in New York. Contact him at rderose@HL.com
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