SOURCE: @ Photopia
CHAPTER
Capital Stru ctur e
and Lever age
94
13
shown on its balance sheet was 90 percent debt and 10
percent equity.
At first glance, a 90 percent debt ratio seems
extraordinarily high. In the past, there have been
numerous examples of high debt pushing otherwise
well-regarded companies into bankruptcy. For example,
a few years ago, two of the nation’s largest retailers,
Federated Department Stores and R.H. Macy, were forced
to declare bankruptcy as a result of their excessive use
of debt.
With these examples in mind, some analysts are
concerned that General Mills may have taken on too
much debt. These concerns have recently increased. The
company has issued more debt and has repurchased
common stock, to the point where the company had
negative equity on its year-end 2000 balance sheet.
Moreover, these numbers do not reflect General Mills’
recent plans to acquire Pillsbury assets from Diageo PLC.
General Mills plans to finance the purchase by issuing
more than $5 billion in stock. The terms of the deal also
require General Mills to assume $5.14 billion of
Pillsbury’s debt.
Despite these concerns, General Mills’ high debt ratio
might be appropriate, given the stability of its basic
business. After all, the consumption of Cheerios and
Hamburger Helper has historically remained stable even
hen a firm expands, it needs capital, and that
capital can come from debt or equity. Debt has
two important advantages. First, interest paid
is tax deductible, which lowers debt’s effective cost.
Second, debtholders get a fixed return, so stockholders
do not have to share their profits if the business is
extremely successful.
However, debt also has disadvantages. First, the
higher the debt ratio, the riskier the company, hence
the higher its cost of both debt and equity. Second, if a
company falls on hard times and operating income is
not sufficient to cover interest charges, its stockholders
will have to make up the shortfall, and if they cannot,
bankruptcy will result. Good times may be just around
the corne