E. I. Du Pont de Nemours and Company (1983)
1. Why should a firm have a capital structure policy, i.e. a target debt ratio?
A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies. Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms. This clearly indicates that there must be benefits from having a target debt ratio.
The trade-off theory implies a target-adjustment model (Taggart, 1977; Jalilvand and Harris, 1984; Ozkan, 2001). In this model, firms set tentative debt ratios to which they gradually adjust. Firms with a debt ratio below the target ratio adjust their debt upward toward the target debt ratio and vice versa. The behaviour depicted is indicative that a firm can use target debt ratio as a guiding principle to follow. The target debt ratio is taken to be a reference point which enables value maximization for the firm.
The capital structure policy needs to be consistent with the firms’ funding needs, given the uncertainty of their future operating incomes. This means that a firm should employ a capital structure that provides a certain level of financial flexibility. Financial flexibility represents the ability of a firm to access and restructure its financing with low transaction costs. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to fund investment at low cost when profitable opportunities arise. The importance of financial flexibility can be seen in E.I. du Pont de Nemours and company (Du Pont) case. Du
A capital structure policy aims to balance the trade-off between the benefits of debt financing (interest tax shield) and the costs of debt financing (financial distress and agency costs). Every firm should set its target capital structure such that its cost and benefits of leverage ultimately maximise the firm’s value. Graham and Harvey asked 392 firms’ chief financial officers whether they use target debt ratios. Results show that the majority of them do, although the level of strictness of the target policy varies across different companies. Only 19% of the firms avoid target ratios, of which most are likely to be the relatively smaller firms. This clearly indicates that there must be benefits from having a target debt ratio.
The trade-off theory implies a target-adjustment model (Taggart, 1977; Jalilvand and Harris, 1984; Ozkan, 2001). In this model, firms set tentative debt ratios to which they gradually adjust. Firms with a debt ratio below the target ratio adjust their debt upward toward the target debt ratio and vice versa. The behaviour depicted is indicative that a firm can use target debt ratio as a guiding principle to follow. The target debt ratio is taken to be a reference point which enables value maximization for the firm.
The capital structure policy needs to be consistent with the firms’ funding needs, given the uncertainty of their future operating incomes. This means that a firm should employ a capital structure that provides a certain level of financial flexibility. Financial flexibility represents the ability of a firm to access and restructure its financing with low transaction costs. Financially flexible firms are able to avoid financial distress in the face of negative shocks, and to fund investment at low cost when profitable opportunities arise. The importance of financial flexibility can be seen in E.I. du Pont de Nemours and company (Du Pont) case. Du