Capital Structure the Three Companies

Capital Structure

The three companies I chose to represent the national grocery chain, the hotel chain and the electronics producer are Safeway, Choice Hotels, and Dell Computer.

Safeway (NYSE: SWY) is representative of a national supermarket chain. They operate in select markets coast-to-coast, and have stores in Canada and Mexico as well. Safeway has over 1700 stores. Safeway's beta is 0.99. The grocery business is non-cyclical due to the demand inelasticity for grocery items. In their regions of operation (west coast, Texas, Chicagoland and the Mid-Atlantic) their customer base is very broad, covering most consumer groups.

Choice Hotels (NYSE: CHH) operates a number of hotel and motel brands, including Comfort Inn, Sleep Inn, Econo Lodge, Quality, Clarion and Comfort Suites. In total, they have over 5500 hotels open, with over 1000 more in development. They operate in 49 states and 39 countries internationally. The beta for Choice Hotels is 1.44, reflective of their reliance on business and recreational travel. The hotel industry is intensely competitive, and Choice Hotels is attempting to compete by saturating the market with their brands.

The manufacturer and seller of high tech electronics I chose is Dell (Nasdaq: DELL). Dell Computer manufactures and retails personal computers, servers and software. They are one of the leading online retailers in the world. They also provide some it services. A significant component of Dell's business is B-2-B, while the PC segment has a significant number of B-2-C customers as well. The beta for Dell is 1.14.

The ideal capital structure for Safeway is a low debt ratio. They operate in a mature industry, and they track the market closely. Their products are basic consumer goods, and their customers are sufficiently broad-based as to represent the entire consumer economy. The primary benefit of increasing leverage is to increase risk and, theoretically, earnings per share as a result. Safeway, however, has limited opportunity for growth so the increased debt would not yield any benefits.

By maintaining a low debt ratio, Safeway would keep their risk in line with the potential growth in revenues and profits they have. Incremental growth is a reasonable strategy, and that can be facilitated through a limited amount of debt.

The ideal capital structure for Choice Hotels is a medium debt ratio. The hotel industry is highly competitive and sensitive to economic shifts. There are low barriers to entry, which intensifies competition. Combined with the fact that the product/service is perishable, the industry bears significant risk. The customers have limited brand loyalty, and are prone to reducing hotel usage in tight economic times. The medium debt ratio allows Choice some risk, but protects against the downside risk inherent in the industry. The cyclicality of Choice, evidenced by their beta, and the intense competitive pressures, means that the firm is at risk for periods of difficulty. If they are too highly-leveraged, these periods could cause irreparable harm to the company. Ideally, Choice would limit the downside damage caused by the inevitable turbulent times. The medium debt ratio achieves this.

The ideal capital structure for Dell Computers is a high debt ratio. Dell's business is growing. From their beta we can infer that Dell itself is relatively stable, since they have such a broad customer base. They sell to both businesses and consumers, with several of their product lines being business only. Thus, the bulk of their risk is market risk.

The high debt ratio gives Dell sufficient leverage to participate in their industry's growth. Without a strong cyclical downside, they are in a good position to take on a higher debt ratio, since they are unlikely to experience a strongly negative environment. They will, however, have ample opportunities to enter new markets or exploit rapidly growing markets. The result is that Dell stands to reap significant benefits from a high-leverage situation, but does not have much downside volatility.

The asset beta for Safeway calculates out as 2.063. This reflects a medium to low debt-to-equity ratio of 1.63. Safeway's asset beta evidences a company that has relatively low asset risk, a testament to the stability of their business. This relatively low asset beta is therefore expected.