CHAPTER EIGHTEEN HOW MUCH SHOULD A FIRM BORROW? We found that debt policy rarely matters in well-functioning capital markets. Few financial managers would accept that conclusion as a practical guideline. If debt policy doesn’t matter, then they shouldn’t worry about it | Brealey-Meyers Principles of Corporate Finance Seventh Edition V. Dividend Policy and Capital Structure The McGraw-Hill Companies 2003 18. How Much Should A Firm Borrow CHAPTER EIGHTEEN HOW MUCHyHOUL A FIRM BORROW- 488 Brealey-Meyers Principles of Corporate Finance Seventh Edition V. Dividend Policy and Capital Structure 18. How Much Should A Firm Borrow The McGraw-Hill Companies 2003 IN CHAPTER 17 we found that debt policy rarely matters in well-functioning capital markets. Few financial managers would accept that conclusion as a practical guideline. If debt policy doesn t matter then they shouldn t worry about it financing decisions should be delegated to underlings. Yet financial managers do worry about debt policy. This chapter explains why. If debt policy were completely irrelevant then actual debt ratios should vary randomly from firm to firm and industry to industry. Yet almost all airlines utilities banks and real estate development companies rely heavily on debt. And so do many firms in capital-intensive industries like steel aluminum chemicals petroleum and mining. On the other hand it is rare to find a drug company or advertising agency that is not predominantly equity-financed. Glamorous growth companies rarely use much debt despite rapid expansion and often heavy requirements for capital. The explanation of these patterns lies partly in the things we left out of the last chapter. We ignored taxes. We assumed bankruptcy was cheap quick and painless. It isn t and there are costs associated with financial distress even if legal bankruptcy is ultimately avoided. We ignored potential conflicts of interest between the firm s security holders. For example we did not consider what happens to the firm s old creditors when new debt is issued or when a shift in investment strategy takes the firm into a riskier business. We ignored the information problems that favor debt over equity when cash must be raised from new security issues. We ignored the incentive .
