In Practice Optimal Debt Ratios for Private Firms

Although the trade off between the costs and benefits of borrowing remain the same for private and publicly traded firms, there are differences between the two kinds of firms that may result in private firms borrowing less money.

• Increasing debt increases default risk and expected bankruptcy cost much more substantially for small private firms than for larger publicly traded firms. This is partly because the owners of private firms may be exposed to unlimited liability, and partly because the perception of financial trouble on the part of customers and suppliers can be much more damaging to small, private firms.

• Increasing debt yields a much smaller advantage in terms of disciplining managers in the case of privately run firms, since the owners of the firm tend to be the top managers, as well.

• Increasing debt generally exposes small private firms to far more restrictive bond covenants and higher agency costs than it does large publicly traded firms.

• The loss of flexibility associated with using excess debt capacity is likely to weigh much more heavily on small, private firms than on large, publicly traded firms, due to the former's lack of access to public markets.

All the factors mentioned above would lead us to expect much lower debt ratios at small private firms.

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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