Phenomenon that Effect Firm’s Capital Structure During a Crisis

When the macroeconomic environment around any firm turns sour, managers must reevaluate where the company stands and where its resources should be allocated. In order to maximize shareholder wealth, most firms have chosen a general debt/equity level that they believe provides the most value to the company. When a large shock hits the market, i.e. the recent financial crisis, new factors must be taken into account.

Suppose you are the CEO of a large publicly traded car manufacturer in the United States, and the financial crisis has just set in. Before the crisis, your company hired a financial firm that found that the optimal debt ratio to be roughly a 40/60 split between debt and equity. As soon as the crisis begins the firm’s equity levels will start to fall, possibly drastically. This is a result of investors realizing the mispricing in the market and trying to sell their shares. The problem with this fast change in equity level is that your firm may now be far away from their target asset ratios. To continue our example, imagine in the crisis your car company’s stock price fell by one-third. Now the firm has a 50/50 debt-equity ratio. This can be dangerous, particularly for firms that already have high distress costs. Adding to the danger, recession causes individuals to cut spending in consumer spending. This means fewer sales for the firm, a drop in equity level, and higher overall debt ratios.

Firms have a few options to combat this risk. First they can provide themselves a buffer by keeping debt levels below their calculated ‘optimal capital structure’ prior to the recession. Keeping the debt slightly below what investors believe is optimal gives the firm opportunities to be flexible in an emergency. If this is not an option, firms may look at refinancing their debt through the banks. Refinancing for firms in a recession usually means extending the length of the agreement, while reducing each individual payment. Also, in this time it is more difficult for a firm to project cash flows or anticipate changes in the market. For these two reasons we see a general shift away from short-term debt and more towards long-term financing during the crisis period.

Lastly, recessionary periods cause managers to be more selective in choosing investment projects. The CEO of our car company is going to be much more wary of building a new manufacturing plant if he knows the market is in a downturn. Firms in cyclical industries, like our example, typically try to use a lean capital structure. This means that in the months where the product does not sell well the firm take on more debt and vice versa. The problem is that during a recession sales fall and more volatility is introduced. Firms must then make the decision: do the benefits from the added capital outweigh the distress associated with debt financing?