Academic journal article Business Economics

Leverage Risk in the Nonfinancial Corporate Sector

Academic journal article Business Economics

Leverage Risk in the Nonfinancial Corporate Sector

Article excerpt

Leverage Risk in the Nonfinancial Corporate Sector

DURING THE RECENT economic expansion, the nonfinancial corporate sector accumulated debt rapidly, initially in response to rising business investment and then to corporate restructurings that resulted in massive equity retirements. Mergers, leveraged buyouts, and share repurchases have become popular largely in response to greater competitive pressures in the marketplace. With the emphasis on enhancing shareholder value, cash flow has been diverted from less productive investments. The more efficient use of capital may benefit many firms and the economy over the longer term. Nevertheless, this debt buildup has left many firms highly leveraged and vulnerable to adverse economic or financial developments.

CORPORATE FINANCE IN THE 1980s:

DEBT-FOR-EQUITY BOOM

Firms can finance capital expenditures from internal sources by using cash flow from depreciation charges, or by retaining a portion of after-tax earnings rather than distributing it to shareholders in the form of dividends. Firms also turn to external sources of funds in the capital markets by issuing debt or equity. The difference between capital expenditures and internal funds - the financing gap - is a major determinant of a firm's need to raise funds in the capital markets. In past business cycles, debt financing rose as the financing gap increased (see Figure 1).

Debt financing among U.S. nonfinancial corporations has surged during the current economic expansion. Use of debt rose by $833.2 billion from yearend 1982 to the third quarter of 1988, or $146.4 billion annually (see Figure 1). This increase occurred even though capital expenditures exceeded internally generated funds by a mere 6.6 percent, or $21.8 billion annually. Instead, the debt buildup was largely related to financing of corporate restructurings that resulted in massive net equity retirements totalling $371.5 billion.(1) Debt financing has been more heavily relied upon in the 1980s than in any other postwar period, but it is the debt-for-equity explosion that makes the 1980s unique and financial risk higher.

Debt Growth More Onerous With Lower Inflation

The sharp decline in inflation in the 1980s makes the debt-for-equity boom riskier. During previous periods of rising and high inflation, growth in debt financing could be discounted by the degree to which inflation eroded firms' real liabilities. Adjusting corporate financing trends properly for inflation better illustrates the degree to which firms have levered up in the 1980s and demonstrates that the recent debt buildup has not been dominated by cyclical or long-term trends.

When capital market participants anticipate inflation, bondholders or lenders demand higher interest rates that include an inflation premium to compensate them for the decline in the real value of their loan. The full interest payment is deducted from and thus lowers reported profits even though the inflation premium represents a repayment of real principal rather than an expense to the corporation. Thus an increase in debt issuance just equal to inflation can be thought of as a rollover of that portion of real principal, and not as net new debt issuance. When inflation is unexpected, moreover, the loss in lenders' real claims should be regarded as a gain to shareholders. This gain may not be realized as additional cash flow but certainly allows nominal debt to expand without increasing the real burden of the firm.(2)

Table 1 shows the corporate sector's reliance on gross internal funds and total debt over the past thirty-five years, using figures both adjusted and unadjusted for changes in real net indebtedness. funds are expressed as fractions of total sources of funds. The inflation adjustment adds back to internal funds the portion of the growth in net financial liabilities (liabilities minus assets) attributed to inflation, and the inflationary rise in net liabilities is subtracted from the change in total debt. …

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