Question

In general, U.S. firms:

tend to overweigh debt in relation to equity.

that are highly profitable tend to have lower target debt-equity ratios than unprofitable firms.

tend to maintain similar capital structures across all industries.

tend to maximize the use of every dollar of the tax benefits of debt.

that are family-owned tend to have very low levels of debt.

Answer 1

The capital structure and leverage decision varies across firms and industries.

1. Tend to overweigh debt is relation to equity - This cannot be true for all firms as not all firms use a high degree of leverage.

2. As debt is inherently risky, lenders and investors tend to favor businesses with lower D/E ratios. A higher ratio suggests higher risk and that the company is financing its growth with debt. Profitable firms experience an increase in equity as profits accumulate causing their debt ratios to fall below targets. This is the reason that profitable firms have lower debt to equity ratios.

3. Maintaining the same capital structutres across industries is not a realistic statement as each firm has different objectives and requirements.

4. Interest on debt payments is tax deductible, while dividends paid to shareholders are not. Companies make decisions on the basis of present value of tax that they would have to pay on an extra dollar of profit. So they tend to maximize the use of every dollar of the tax benefits of debt.

5. A longer-term planning horizon and more moderate risk taking serve the interests of debt holders too, so family businesses tend to have not only lower levels of financial leverage but also a lower cost of debt as compared to other firms.