632598256894

Company A has insufficient cash flow to pay its debt service and invest in all of its good projects.
Since debt service is contractual, Company A is required to pay its debt service first, so the firm will
be unable to invest in all of its good projects. If economic conditions worsen and Company A falls
into financial distress and the market value of the firm‟s debt and equity falls significantly in value,
the managers of Company A (who work for the stockholders) may consciously choose not to invest in
good projects if the benefits of the projects flow only to the debt holders. These two effects combined
are called the underinvestment problem, because in some instances the use of debt finance can cause
the firm to underinvest, that is, not invest in all of its available good projects.
Compare this scenario to Company B, which has many good investment opportunities and little or
no debt finance and debt service. With little or no debt service, Company B is much less likely to
experience the underinvestment problem; in both strong and weak economies cash flow is more likely
to be sufficient to fund all good investment opportunities, so Company B is more likely to be able to
invest in all of its good projects. Recall that this underinvestment problem is especially troublesome
for fast-growing firms in fast-growing and risky industries, which in Exhibit 5.9 best describes the
three technology companies, Apple, Cisco, and Intel, which also have the lowest amount of debt
finance. This result has been obtained consistently by financial researchers, so we can conclude that
companies with large investment opportunities experiencing high growth rates in riskier industries
tend to use significantly less debt finance in their capital structures.
Consistently profitable firms in lower-risk and slower-growth industries, in contrast, should use
more debt in their capital structures. Companies with these characteristics have fewer investment
opportunities, so the underinvestment problem created by the use of debt finance is not as
troublesome. They are also in less volatile industries, with beta coefficients at or below 1.0, so their
revenues, profits, and cash flows are more stable. These firms are also more likely to be consistent
taxpayers, so they can take full advantage of debt tax shields. Since they are less risky and more
stable, they will also have lower expected costs of financial distress, so the negative implications of
debt finance are smaller. These predictions about capital structure are supported by financial research,
which has found that companies with fewer investment opportunities and growth prospects in lowerrisk
industries use significantly more debt finance. The data in Exhibit 5.9, taken at a single point in
time in November 2008, also somewhat support these findings in that the consumer products
companies, which operate in a low-risk and slow-growth industry with fewer investment
opportunities, have more debt finance than the technology companies. Of course, the companies with
the highest debt percentages in Exhibit 5.9, the three retailers, are all in a slower-growth industry with
fewer investment opportunities, but their beta coefficients are all above 1.0, so they also operate in a
riskier industry. These particular three retailers, therefore, use more debt consistent with fewer growth
opportunities, but inconsistent with their higher than average risk.
In conclusion, financial research has found several regularities in capital structure in real
companies. Safe and consistently profitable firms with fewer growth opportunities should and do use
more debt finance. Riskier companies in high-growth industries with large investment opportunities
should and do use less debt finance. Variability around these predictions can be observed, but research
has found these results to be both statistically and economically significant. These results are more
consistent with the trade-off theory of capital structure, but some of the data shown in Exhibit 5.9 also
supports the pecking order theory. The three technology firms with the lowest debt percentages in
their capital structures have also been extremely profitable in recent years, so their internal sources of
capital have been sufficient to fund their investment opportunities. At this time, financial research is
unable to accept or reject either the trade-off theory or the pecking order theory with certainty, but we