The potential for earning abnormal profits will attract new entrants to an industry. The

very threat of new firms entering an industry potentially constrains the pricing of exist-

ing firms within it. Therefore, the ease with which a new firm can enter an industry is a

key determinant of its profitability. Several factors determine the height of barriers to

entry in an industry:

Economies of Scale When there are large economies of scale, new entrants face the

choice of having either to invest in large capacity which might not be utilized right

away, or to enter with less than the optimum capacity. Either way, new entrants will at

least initially suffer from a cost disadvantage in competing with existing firms. Econo-

mies of scale might arise from large investments in research and development (the phar-

maceutical or jet engine industries), in brand advertising (soft drink industry), or in

physical plant and equipment (telecommunications industry).

First Mover Advantage Early entrants in an industry may deter future entrants if there

are first mover advantages. For example, first movers might be able to set industry stan-

dards or enter into exclusive arrangements with suppliers of cheap raw materials. They

may also acquire scarce government licenses to operate in regulated industries. Finally, if

there are learning economies, early firms will have an absolute cost advantage over new

entrants. First mover advantages are also likely to be large when there are significant

switching costs for customers once they start using existing products. For example,

switching costs faced by the users of Microsoft’s Windows operating system make it dif-

ficult for software companies to market a new operating system.6

The potential for earning abnormal profits will attract new entrants to an industry. The

very threat of new firms entering an industry potentially constrains the pricing of exist-

ing firms within it. Therefore, the ease with which a new firm can enter an industry is a

key determinant of its profitability. Several factors determine the height of barriers to

entry in an industry:

Economies of Scale When there are large economies of scale, new entrants face the

choice of having either to invest in large capacity which might not be utilized right

away, or to enter with less than the optimum capacity. Either way, new entrants will at

least initially suffer from a cost disadvantage in competing with existing firms. Econo-

mies of scale might arise from large investments in research and development (the phar-

maceutical or jet engine industries), in brand advertising (soft drink industry), or in

physical plant and equipment (telecommunications industry).

First Mover Advantage Early entrants in an industry may deter future entrants if there

are first mover advantages. For example, first movers might be able to set industry stan-

dards or enter into exclusive arrangements with suppliers of cheap raw materials. They

may also acquire scarce government licenses to operate in regulated industries. Finally, if

there are learning economies, early firms will have an absolute cost advantage over new

entrants. First mover advantages are also likely to be large when there are significant

switching costs for customers once they start using existing products. For example,

switching costs faced by the users of Microsoft’s Windows operating system make it dif-

ficult for software companies to market a new operating system.6

Miller and Modigliani showed in 1961 (Journal of Business) that it does not matter how a firm

finances itself. Ross (Bell Journal of Economics, 1977) and Leland and Pyle (Journal of Finance,

1977) show that an optimal financial structure exists because of signaling costs. Lewellen (Journal

of Finance, 1975) and Galai and Masulis (Journal of Financial Economics, 1984) show that an

optimal financial structure exists because of bankruptcy costs and taxation.

4 See “Corporate Debt Value, Bond Covenants and Optimal Debt Structure,” by Hayne Leland

(Journal of Finance, September 1994).

Other financial theories suggest that entrepreneurs have incentives to issue

shares in their firms to the public, in effect, raising more internal capital when they

consider current stock prices too high. Thus they issue additional shares of the

firm to the public and enjoy the benefits of cash infusion into the firm that is not

justified by the firm’s cash flows. Conversely, when firms purchase stock in them-

selves, they likely consider the price too low compared with their cash flows. Thus

they repurchase the firm’s stock, reducing internal capital. In reality, while many

soundly financed firms with good cash flows have repurchased their own stock,

too many others have done so succumbing to the pressure of vocal shareholders

who believed that buyback programs will lend support to the stock price, imply-

ing that the stock price was not correctly discounting prospective free cash flow.

Also, for a firm to constantly buy and sell its own stock would send a signal to the

financial markets that could harm the stock valuation. Besides, no company has a

crystal ball.

Information asymmetry almost always exists between insiders and outside

investors, and it also may exist between shareholders and bondholders. For

example, stock repurchases reduce total shareholders’ equity, and shareholders

may wish to accept certain capital projects or acquisitions that are too risky for

bondholders.

One common characteristic of all financial theorists is that the financial

structure of a firm does not usually lie in either extreme case; that is, firms are nei-

ther all equity nor all debt. Rather, they are a mixture of internal and external cap-

ital. Another common characteristic of the theories is that firms are not at their

optimal structure at all times. Instead, they continuously make adjustments to their

financial structure in an attempt to react to changing economic and market condi-

tions so that they can reach their new optimal financial structure. Thus we should

observe that firms adjust their capital structure in almost every period, as can,

indeed, be verified from any casual examination of the financing cash flows of

firms. These adjustments are more earmarked toward leverage, not equity

issuance.

Can one predict how adjustments to the financial structure of a firm should be

related to operating and free cash flow? To answer this question, recall that one of

the major disadvantages of external capital is the possibility of bankruptcy and reor-

ganization costs to shareholders. These expected costs relate to the likelihood of

financial difficulties for the firm; the higher the likelihood of financial difficulties,

the greater are the expected bankruptcy costs, and the more costly external financ-

ing becomes. An immediate variable to consider for the likelihood of financial dif-

ficulties is the stability of operating and free cash flow. The more stable5 operating

and free cash flows are, the lower is the probability of financial difficulties, and the

lower is the probability of bankruptcy. Thus firms with stable but growing operating

and free cash flows are expected to be characterized by higher financial leverage

than their counterparts, where financial leverage can be measured by the relative

proportion of debt to equity, including all forms of external financing. Such firms are

also more likely to be increasing external capital at the expense of internal capital.

Assumed in all this is the soundness of the nation’s banking system and, for individ-

ual entities, the soundness, reliability, and diversity of any backup financing agree-

ments in place.

For entities that have entered bankruptcy but have shown a history of ade-

quate but cyclicality in their cash flows, creditors have a reasonable opportunity

at recouping some to all of their capital. Pilgrim’s Pride, a large poultry company,

saw its senior unsecured debt trade as low as 14 cents on the dollar with the firm

being in Chapter 11 bankruptcy; when the firm was offered $2.6 billion in a buy-

out, those bonds went back up to par. Unfortunately, stockholders received very

little from the deal.

Firms that exhibit volatile operating cash flows and firms that are character-

ized by negative free cash flow are expected to have lower financial leverage and,

on average, are expected to show decreases in debt and increases in equity financ-

ing when conditions permit.

While the optimal financial structure is one of constant debate, in reality, it

can be only determined with perfect foresight. This is so because the optimal mix

of debt and equity is a function of future cash flows and the assets required to pro-

duce those cash flows. If the firm knew for certain its operating cash flows, it

would adjust its capital structure accordingly, including lining up any necessary

financing that needed to take place from secure sources. The optimal structure

would, in essence, be that level where the entity is capable of producing the high-

est free cash flow consistent with its ability to retire its contractual obligations

and allowing a measure of financial flexibility. There is a continual dynamic

tradeoff between that financial structure and the time it takes for normalized

operating cash flows to retire all outstanding obligations. Investors and corporate

executives must evaluate the risk of nonpayment of debt if the operating cash

flows are less than expected and whether the increase in leverage ratios is worth

the added cash flows. As we saw in the case of Clorox, part of the analysis is

available liquidity aside from what is listed on the balance sheet. Committed

unused credit lines, including contingent equity, must be considered when evalu-

ating the optimal structure for a particular company. Two companies having the

same expected operating and free cash flows should have different leverage ratios

if they have dissimilar credit lines available. Likewise, if they have dissimilar

costs of capital, the company having the less risk (lower cost of capital) would be

expected to withstand higher leverage.

Cash-flow analysis can provide worthwhile clues to impending financial

risk and return. Unfortunately, many entities reporting a healthy operating gain

after years of negative free cash flow often find themselves unprepared to oper-

ate during an ensuing business downturn. Because traditionally they have been

heavy users of cash (with commensurate increases in debt), they cannot build

the sufficient liquidity cushion necessary as conditions improve. Some entities,

however, have been successful using a financing “window” to enhance their

capital structure potential.