Capital structure and the debt-equity financing combination

Debt and Credit Financing

While there are general rules that each company can rely on to help it determine the best strategies for determining how to finance its short-term and long-term goals. However, as this analysis shows, each company must make financing decisions based on its specific needs and market position.

Companies exist to make money. However, in order to be able to create the products or services with which they can make money, companies also have to be able to bring in money before the point of sale. Building up an inventory requires money (or other forms of capital) and no company can succeed unless it has a well-thought-out and well-defined strategy for financing its ongoing expenses as well as any extraordinary long-term expenses such as building a new factory.

Balancing long- and short-term goals is difficult enough, especially given how volatile the overall economic marketplace can be (as we have all seen to dramatic effect over the last few years). What makes decisions about how to design the financing mix for a company even more difficult and complex is that each company has a particular mixture of debt and equity financing that will serve it best at any given moment.

This mixture is determined by overall market conditions, the position the company holds in its particular market, the history of the company (including such factors as whether it is a start-up, etc.), how closely the company's finances are held (is it a publicly traded company or not), and the nature of its product (including whether it is seasonal, whether it is highly subject to fluctuations in demand, and whether it contains aspects that -- like Beanie Babies -- are highly likely to affect its long-term profitability and stability. This paper examines three important American companies -- Campbell's Soup, Goodyear, and Hewlitt-Packard -- to determine what (given current market conditions) the best ratio of debt financing to equity financing.

Before proceeding to discuss the specific strategies that each company should consider taking given the current set of market conditions, it is important to outline the two basic options that a company has in terms of financing its operations. (This is assuming that the company is "normal" in terms of its financing and is not an exception like a vanity project or a form of nepotism.)The first basic way in which a company can finance itself is through borrowing money, that is, through the process of acquiring debt. This is the same process that individuals use in borrowing money to pay for a mortgage or a new car.

There are both upsides and downsides for a company to go into debt to get the money that it needs to run its operations. When a bank, individual, or other entity lends to a company, company officials are relatively free to do what they want with the money. While they will be enjoined from doing anything illegal with the money and will generally have made an agreement with the lender about what the money is for (a plant expansion, for example, or a new IT system), a lender does not gain any managerial or operational control over the company.

This is analogous to the ways in a person is affected when she gets a car loan. The lender may require the person to get car insurance so that there is a way to pay back the loan if there is an accident; however, the lender cannot tell the borrower what color car she can buy or what radio stations to listen to. So long as the borrower repays the money on the schedule that s/he has agreed to, then the borrower has a very high degree of freedom in terms of what s/he can do with the money (Peavler, 2011).

The above describes the major advantage of acquiring debt to run a company: Acquiring debt gives a company needed capital without giving the lender control over the company's direction. However, there are also disadvantages of acquiring debt. The primary of these is that as a company becomes increasingly indebted it can become a target for takeover by another company. Also, a company that has a high level of debt will have less flexibility. Also, because a company has to repay its debt it may have to make relatively conservative decisions that it would not have to make otherwise (Damodaran, 2005).

The other major way in which companies can finance their activities is through equity financing. This can be seen as a mirror image of debt financing because under this system of financing the company does not have to take on debt. Instead, an individual or an institution gives money to a company. (This is what venture capitalists do as well as what "angel investors" do.) This strategy allows the company to avoid going into debt, which relieves it of the disadvantages of debt financing (as described above).

However, while equity financing allows a company to avoid going into debt, it is not without its own limitations. When a company allows an investor to acquire equity in the company, then that person or institution also gains a say in how the company is run. This can be a mutually beneficial relationship all around, but it also has the potential to be a relationship filled with a very high level of conflict (Peavler, 2011).

So what is the best strategy for the three companies that are being considered here? Each of these companies has significant strengths, but the degree of strength is not equal among them (Harvey, 1995). Campbell's Soup Company is a well established company with a history of strong sales. It is a company that is affected by seasonal fluctuations to some extent (people living in the desert Southwest are less likely to eat soup in August than they are in December), but the range of products that the company sells is in demand throughout the year.

Moreover, a company that sells moderately priced food is in a good position to avoid being severely affected by even serious economic downturns. Indeed, as people find themselves eating out less and less during the recession they are likely to turn to prepared foods that they can eat at home even more, thus guaranteeing a good market for Campbell's. A company that has such strong fundamentals can rely on a higher debt load without becoming weakened by this fact while at the same time avoiding the problems associated with equity financing.

Goodyear is in a different economic position. Because tires are relatively expensive, the company is more subject to being affected by bad economic times. A company that is subject to rather dramatic fluctuations in its income (and this is generally truer of companies that produce expensive items as opposed to cheaper ones) should avoid a high-debt ratio situation. It is less likely to be able to meet debt obligations and so may wish to trade the risks of repayment for the risks of interference by those holding equity in the company. A moderate debt-ratio is likely to be the best choice for Goodyear.