Corporate Debt Capacity and Capital Budgeting Analysis

Abstract

Traditionally, financial management theory has emphasized the separation of the capital investment and financing decisions [2, pp. 81 and 176]. This separation assumes that the firm's financing decision is taken as given when the investment decision is made or that the two decisions are independent of each other. In reality, these decisionis are seldom independent. Mergers and acquisitions are typical examples of capital investments that make the investment/financing separation inappropriate. The tone of research on the interaction between investment and financing decisions was set by Myers [16]. Myers advanced the concept of Adjusted Present Value (APV), which permits an examination and evaluation of the consequences of interactions between the firm's financing and investment decisions. A new project's APV is defined as the sum of the present value of its net operating income assuming all-equity financing plus the value of any additional debt capacity to the firm contributed by the project. The definition of the new project's APV presented above represents a fairly simplified version. However, a closer look at the concept of APV brings up other potential issues relating to stock purchase decisions, dividend policy, and transaction costs associated with new sources of funding, etc. These are important financial management variables that have been considered in other research efforts [1, 3, 7, 17]. The second phase of the investment/financing interaction process was developed by Bower and Jenks (BJ) [1]. They used the simplified concept of APV in their effort to estima e divisional screening rates for decentralized investm nt decisions. After assuming that each investment project had its implicit optimal debt ratio, BJ used this implicit ratio to estimate the project's cut-off rate in the fr m work of the capital asset pricing model. While BJ's study does provide an important application of the APV concept, it does not go far enough: (a) It does not provide any theoretical basis for assessment of the implicit debt ratio of each project. Their analysis instead relies on average debt ratios of different industries observed on an ex post basis. (b) It assumes that the firm's debt capacity is increased by an amount equivalent to the project's debt capacity. Although the additivity of the firm's debt ca-