This paper examines the capital structures of three publicly traded companies — Goodyear Tire and Rubber Co. (GT), Campbell Soup (CPB), and Hewlett-Packard (HPQ) — by comparing each firm's actual debt-to-equity ratio against its theoretically ideal capital structure. The analysis considers the maturity of each company's industry, the stability of its cash flows, and the trade-off between the lower cost of debt financing and the financial flexibility provided by equity. The paper concludes that mature businesses with stable cash flows can sustain higher leverage, while companies operating in dynamic, competitive environments must exercise greater caution when increasing debt obligations.
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A company's capital structure is the balance of different financing methods that fund the company's operations. The basic breakdown is between debt and equity, though preferred shares may also factor into the capital structure. Debt includes all forms of liabilities, encompassing both long-term debt and current liabilities. Equity includes both the book value of shares issued and the company's retained earnings. The market value of shares is not relevant when calculating the firm's capital structure.
Analyzing a company's capital structure begins with calculating the proportions of debt and equity. Because debt and equity carry different risk characteristics, the ideal capital structure must be evaluated against the type of business model the company operates. Different risk profiles are considered optimal for different types of companies. This report analyzes the capital structures of three companies — Goodyear (NYSE: GT), Campbell Soup (NYSE: CPB), and Hewlett-Packard (NYSE: HPQ) — and draws conclusions regarding how well each company's actual capital structure aligns with its theoretical ideal.
The capital structure for Goodyear at the time of this analysis was 91.6% debt and 8.4% equity (MSN Moneycentral, 2011). The company had maintained a similar capital structure for several years prior. As recently as 2006, Goodyear carried negative equity, reflecting a long history of being highly leveraged. Leverage increases the risk associated with owning a company's equity, since a large portion of the firm's free cash flow must be dedicated to debt service, which typically takes priority over distributions to shareholders. High leverage also reduces the amount of money available for expansion, placing limits on growth and on the company's ability to pursue competitive opportunities.
Goodyear's business is mature. The company operates in the consumer goods sector and has been in business for decades. Its core businesses — tires and rubber — are broadly mature, with tire sales depending heavily on the automobile market, which is itself mature in the United States. Goodyear's revenues over the five years preceding this analysis confirm that it operates in a mature industry: revenues for 2010 were just 0.4% higher than revenues for 2006. The company made no substantial acquisitions or divestitures during that period that would have significantly altered its size or shape. Only once in those five years did Goodyear record a positive net income, further indicating that the market is either mature or possibly in decline.
The optimal capital structure for Goodyear can be weighted toward debt for two reasons. First, the company does not need funds for significant expansion. Second, debt carries a lower cost than equity, so a higher proportion of debt reduces the firm's weighted-average cost of capital (WACC). However, Goodyear's capital structure at the time of this analysis was weighted too heavily toward debt. The bare minimum of equity the company carried was more reflective of its lack of profitability than of a deliberate financing strategy. While increasing equity would raise the cost of capital, it would also signal that the company had found a way to build retained earnings — a healthier long-term position.
Like Goodyear, Campbell Soup operates in the consumer products sector and its business is mature, as evidenced by annual revenues that remained stable in the $7.385–$7.998 billion range over the five years preceding this analysis (MSN Moneycentral, 2011). The firm's profits were also stable, landing in the $800 million range in three of those five years. The maturity and stability of Campbell's business make it a strong candidate for a higher degree of leverage. The company does not need to raise large sums for expansion or to respond to competitive disruption, and it benefits from the lower weighted-average cost of capital that debt financing provides — particularly in a low-interest-rate environment.
Campbell Soup's capital structure at the time of this writing was 84% debt and 16% equity. While this represents a high level of debt, Campbell's consistent profitability gave the company confidence that it would have sufficient funds to service that debt. The company had operated with this capital structure for many years without compromising either cash flow or profits. Given the low cost of capital this structure produces and the stability of Campbell's earnings, the capital structure is appropriate for the company.
"Examines HP's rapidly increasing leverage in a dynamic industry"
The ideal capital structure for a firm depends largely on the nature of its business. Companies must weigh the risks of debt financing — most notably, reduced cash flow flexibility — against its primary benefit: a lower cost of capital. Mature businesses with stable cash flows can generally sustain a higher level of debt.
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