In practice, what is the debt to equity ratios that are considered and finally adopted by firms?
According to Damodaran (n.d.), we can explore four measures to find out the optional mix in the debt to equity ratios. The first way often starts from the operating income’s distribution in the future, from which we may then carry out the decision that we are will to afford the default level in a maximum possibility with the decision of the amount of debt we can carry. The second way is to minimize the capital cost by picking up the debt ratio. The same as the second way, the third approach is also aimed to improve the firm value to the largest degree with putting the unlevered firm’s value to the tax benefits’ value at the present time by putting the possible costs of bankrupt aside. The last way is to make the financing mix on the basis of the measure that how comparable companies finance the operation.
i) Operating income approach
Ehrhardt and Brigham (2009) pointed out the first way is on the basis of operating income, which is based on the past data or forecasts to enable firms to design a operating income distribution means in both positive and negative situation. And then a redefined default on the acceptably probability will be used to further define the borrowing capacity of the firms in their ultimate level. Compared to the other three approach, this approach may be the most intuitive and simple one, it has many limitations.
First, it is a tough task to assess the distribution means for operating income in the changing and full of fierce competition environment. Second, although we may be able to carry out the distribution means for operating income, it may be not the suitable one to meet the requirements of the changes in operating income and the parameters of proper distribution means, which may make the firms in a risk. Third, these constraints in the distribution means of operating income established by the corporate management may be subjective to have more concern on the management issues in the firms instead of the concern on the entire interest of every stakeholder, which may arouse conflicts between management and these stakeholders such as shareholders. (Ehrhardt and Brigham 2009)
Generally speaking, as the simplest approach out of the four measures, this one may be not so suitable for these big companies to adopt but more suitable for these small business.
ii) Debt ratio that minimizes the cost of capital
Binsbergen et al. (2010) held the idea that the other debt ratio is the approach to minimize the cost of capital by weighing the average costs on preferred stock, equity and debt. And the weights in this measure are the weights of market value with the financing costs as the current costs. As the aim of this approach is to minimize the capital cost, it may also have the influence on the value of the firm. So in this approach, the more ideal situation is to make the change of cash flow with the change of debt ratio. That is to say, instead of making the lowest capital cost, this approach is preferred to deliver the highest value to the firm which may also lower the cost in an indirect way.
And for a firm, if its aim is to save cost to the largest extent but not with the risk of pushing the firm into the financial jeopardy, this debt ratio to minimize the cost of capital may be the good choice according to Binsbergen et al. (2010). It is possible to impose the rating constraint of a bond on the analysis of the capital cost for this firm by this approach. That is to say, once applying the constraint, this approach may be the optimal measures for firms to have the cost in the lowest level.
Dempsey (2011) gave us the third option of the debt ratio namely the APV approach which enables firms to assess the firms’ value in different situation with subtracting out the possible costs of bankrupts from the value for the unlevered firms which is already added the tax benefits the value of the present into. Compared to the approach to minimize the capital cost, this approach is to maximize the value for the firms.
Moreover, one of the advantages of this approach is to enable firms to divide the debts’ effects into many components to have a more careful analysis with the usage of rates of discount differently. While the difficulty to calculate the default possibility and cost of the bankrupt may also be a barrier to this approach to be perfect. Dempsey (2011) summarized if it is able for firms to assess a dollar amount adding in debt, APV is a practical approach for firms to choose. But if firms are engaging in the debt proportion analysis, the cost of capital measure may be the most suitable one.
Song and Yong (2009) pointed out the comparative analysis is the final approach of debt ratio. In this kind of approach, there is a common use of the comparison of between the debt ratios of this firm to the industry average.
Song and Yong (2009) also said some companies may also pick up their financial mixes with the comparison of the average level on other firms’ debt ratios in the same industry. For example, table 1.0 is the industry average comparison of debt ratio for Disney,Aracruz and Tata Chemicals with their competitors in their industries respectively, which may help firms to approach the problems and the performance of the firms in the industry with the reference of the industry averages in a short time.
Table 1.0 Comparison to industry averages
Source: Value Line & Capital IQ.
Generally speaking, which option in the four approaches is the best one may depend on the actual situation of the firms and its purpose to choose the debt ratios. Each approach owns its pros and cons, each of which should be applied into the most suitable situation to facilitate firms to get the expected return.