Risk, Technological Change and Long-Term Financing: Public Utility versus Industrial Firms

Abstract

HEAVY LONG-TERM DEBT and preferred stock financing of public utility enterprises has long been an accepted practice. Management has been encouraged to employ high leverage to enhance the rate of return on common equity. Financial analysts have supported such financing by applying lower standards relative to capital structure proportions and earnings coverage of fixed charges to utilities than to industrial corporations.' Regulatory commissions have encouraged it by relating operating income to assets or total capital rather than common stock equity in determining a fair rate of return, and, in some cases, by basing the allowable rate of return upon a hypothetical capital structure incorporating a higher proportion of debt than that existing in the utility company under consideration.2 In contrast, many industrial firms use no long-term debt financing, and those which do tend to use it sparingly. Furthermore, whereas the debt of industrial corporations usually is intended to be eliminated with the passage of time through sinking funds or installment payments on the principal, the debt of public utility enterprises generally is considered to be financing, relying upon refunding for the pay-off at maturity.3 It is the purpose of this article to question the soundness of the great disparity between the capital structures of utility and industrial firms and the assumption of permanent debt in the former. Do (1) the historical record, (2) the economic characteristics of the firms, or (3) the apparent facts of business life in 1965 and beyond, justify the financial policies reflected in these capital structures? If not, what constructive action might be in order?