New Framework for Corporate Debt Policy

Twenty years have gone by since I undertook the study of corporate dept policy on which the book Corporate Debt Capacity^* and the related HBR article were based. The timing of these publications coincided with the advent of a new generation of corporate administrative and financial officers who were free of the anxiety-ridden experience of the 1930s and who were supported by a rising buoyancy in the business environment that did not run its full course until the early 1970s. In many companies investment opportunity was beginning to press on traditional financing decision rules, and the managements of these companies were therefore receptive to the thought that these rules were open to question and independent evaluation.

In retrospect, it seems to me that the use of the phrase “debt capacity” in the title of the book suggested a significant change in attitude with respect to the use of debt: from that of a burden to be minimized to that of a resource to be exploited. Indeed, I have been charged at times with a share of the blame for an excessive use of debt by corporations in the 1960s, with its inevitable day of reckoning in the 1970s.

I think that charge overstates both the influence and the responsibility. It is sobering to think, however, that the use of debt by individuals and corporations may be subject to periodic excesses if it is not held in check by those who are in a position to influence it.

How would the article differ from the original if it were written today? Certain developments of the past sixteen years have had major significance for the issue of corporate debt policy. One of these is the extraordinary series of events—political, social, and economic—during this period.

They remind us that our human and economic environment is as volatile and as unpredictable as it has ever been. The suggestion that nations are now better able to understand and therefore to manage their economies—and thus economic and business risk is on the decline—is hard to sell these days. The unexpected continues to happen: Who predicted an era of recession and inflation? Who predicted (or who believed) the extraordinary consequences of OPEC?

This experience, not lost on corporate managers, has resulted in a sharp swing toward caution and conservatism in financial and fiscal policy in business as well as in government affairs. Corporate financial goals and policies are showing strong signs of concern for solvency in preference to dramatic growth rates in sales and profits.

As the 1962 article made plain, debt policy is the result of perceived risks and attitudes toward risk bearing, and both have undergone significant change. I pointed out at the time that any debt involves some incremental risk, but an article today on this topic would undoubtedly put more emphasis on the use of the proposed analysis for protection against downside risk than for upside opportunity. (It was, in fact, that concern which led me in 1969 to write a book and an HBR article on the use of debt and other financial mobility.^†) It was an Idea whose time had not yet come; it would have much more relevance today.

Along with the changes in the objective and subjective elements of risk associated with debt financing, which in the 1970s have led to more caution in the use of debt, changes were also taking place in the theory of capital markets that perceived less benefit to the stockholder from the use of a leveraged capital structure than had been assumed. The hypothesis that a sophisticated portfolio manager, functioning in an efficient capital market, could duplicate the investment and financing options of the corporation—and he would therefore deny an equity premium to the corporation simply because it chose to finance with debt—has become accepted doctrine in schools of business during the past decade. How far this thinking has permeated the younger generation of business managers is hard to tell.

Certainly a disenchanted investing public, burned by the collapse of the equity markets and the excesses of the 1960s (most notably the EPS game of certain conglomerates projecting an image of unending growth), was receptive to a theory that suggested that value was less a function of individual managerial decisions than it was of fundamental industry risks and returns.

And yet, as the French say, the more things change, the more they remain the same. Despite some dramatic business failures, the last recession showed only a very modest rise in the number of business bankruptcies. Though business is more cautious, it continues to finance with substantial amounts of debt. There is little evidence of a flight from debt securities by investors—quite the contrary. The organizational and practical benefits of debt remain for the manager and, given the tax advantage, for the stockholder also.

But so, also, does the fundamental risk. Thus, it seems to me, the primary message of the 1962 article remains as important as ever: the capacity to assume long-term, fixed-cash commitments is a critical and scarce resource affecting both corporate solvency and strategic expenditure policies. Debt servicing is one such commitment, and the decision on how much debt to use and how much to reserve should not be left to chance or to generalized rules of thumb.

A careful study of the particular industry and company cash flow characteristics will improve the manager’s ability to anticipate the levels of risk associated with various debt contracts. With better information on risk magnitudes, the new conservatism in risk bearing will assume a more meaningful focus.

* Corporate Debt Capacity (Boston: Division of Research, Harvard Business School, 1961).

† Strategy for Financial Mobility (Boston: Division of Research, Harvard Business School, 1969); “Strategy for Financial Emergencies,” HBR November–December 1969, p. 67.