Using up excess debt capacity reduces financial flexibility

As noted earlier, one of the by-products of the conflict between stockholders and bondholders is the introduction of strict bond covenants that reduce the flexibility of firms to make investment, financing, or dividend decisions. It can be argued that this is part of a much greater loss of flexibility arising from taking on debt. One of the reasons firms do not use their debt capacity is that they like to preserve it for a rainy day, when they might need the debt to meet funding needs or specific contingencies. Firms that borrow to capacity lose this flexibility and have no fallback funding if they do get into trouble.

Firms value financial flexibility for two reasons. First, the value of the firm may be maximized by preserving some flexibility to take on future projects, as they arise. Second, flexibility provides managers with more breathing room and more power, and it protects them from the monitoring that comes with debt. Thus, while the argument for maintaining flexibility in the interests of the firm is based upon sound principles, it is sometimes used as camouflage by managers pursuing their own interests. There is also a trade-off between not maintaining enough flexibility (because a firm has too much debt) and having too much flexibility (by not borrowing enough).

So, how best can we value financial flexibility? If flexibility is needed to allow firms to take advantage of unforeseen investment opportunities, its value should ultimately be derived from two variables. The first is access to capital markets. After all, firms that have unlimited access to capital markets will not need to maintain excess debt capacity since they can raise funds as needed for new investments. Smaller firms and firms in emerging markets, on the other hand, should value financial flexibility more. The second is the

Financial Flexibility:

Financial flexibility refers to the capacity of firms to meet any unforeseen contingencies that may arise (such as recessions and sales downturns) and take advantage of unanticipated opportunities (such as great projects), using the funds they have on hand and any excess debt capacity that they might have nurtured.

potential for excess returns on new investments. If a firm operates in a mature business where new investments, unpredictable though they might be, earn the cost of capital, there is no value to maintaining flexibility. Alternatively, a firm that operates in a volatile business with high excess returns should attach a much higher value to financial flexibility.

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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