Introduction to Finance

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Business Risk
Firms in the same industry will generally face the same business risks. 
Many fi nancial managers confess they examine their competitors’ capital structures to 
determine if their own fi nancial strategies are appropriate. A fi rm’s DOL aff ects the amount 
of debt it can issue. Firms with highly variable EBIT cannot aff ord to issue large amounts 
of debt, as the combined eff ects of high business and fi nancial risk may imperil the fi rm’s 
future. In general, greater EBIT variability reduces the fi rm’s reliance on debt.
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Taxes and Nondebt Tax Shields
Under current tax regulations, the debt interest deduc-
tion is a strong infl uence in favor of debt. The tax incentive for debt fi nancing can diminish 
as a fi rm accumulates nondebt tax shields, such as depreciation expense, R&D, and large 
advertising outlays.
Mix of Tangible and Intangible
Assets
Agency costs and bankruptcy costs can make 
debt less attractive as a fi nancing alternative for fi rms with large amounts of intangible assets, 
such as goodwill, customer loyalty, R&D, and growth opportunities.
Financial Flexibility
Among the greatest concern of fi nancial managers is maintaining 
access to capital. Without the ability to raise fi nancing, a fi rm may have to pass up attractive 
investment opportunities, or a temporary cash crunch may push it to the edge of default. Loss 
of fi nancial fl exibility can disrupt the fi rm more than the strictest bond covenants. Some fi rms 
seek fi nancial fl exibility by maintaining fi nancial slack or unused debt capacity. One way to do 
this is to maintain an investment-grade bond rating or to maintain large lines of credit.
It may be good to have fi nancing that can be eliminated if it is unnecessary. The fi rm can 
arrange for debt fi nancing with a maturity matching the expected period of need. For maturity 
matching, debt holds an important advantage over preferred stock or common stock fi nancing, 
because equity securities do not have a stated maturity, which makes it possible to retire them 
conveniently. A lease arrangement for fi xed assets is advantageous, because the lease term 
may be set to coincide with the duration of the need for the assets.