Finance

In order to analyze the capital structure of a company, it is vital to dig into business aspects such as product portfolio, customer segments, market riskiness, and the reasons for preferring debt or equity financing. This paper will focus on three companies, namely, General Dynamics Corporation, Dell Inc., and Sprint Nextel Corporation. I will briefly highlight the nature of their business and industry, their customer segments  characteristics, and the appropriate debt level that the companies can bear.

General Dynamics Corporation
General Dynamics Corporation provides highly sophisticated products and services in aviation, shipping, and information technology sectors. The company operates four strategic business units aerospace, combat systems, marine systems, and information systems (General Dynamics, 2009). The major chunk of their revenue comes from United States Department of Defense and Intelligence.  It also provides services to business aviation for commercial use (General Dynamics, 2009).

General Dynamics works in an industry which is highly capital-intensive because it requires huge investment to be made for achieving the highly sophisticated technological requirements of their services and products. This high fixed cost ensures that the company does not face threats from new entrants in the industry. However, competition from the existing players in the market is intense because of high fixed cost each competitor will try to grab as much market share as possible. Moreover, to retain its customer base and market share, General Dynamics will have to keep investing to upgrade its technology constantly so that their competitors do not snatch their customers away by providing them with the more technically advanced information systems and equipments. Another aspect of their business operations is the immense dependence of their customers on the systems that are being provided by the company. The United States government makes use of various strategic mission systems along with advanced intelligence and tracking systems for their operations. Hence, switching to competitor will not be an easy option for the customers, provided that General Dynamics offers reliable services and achieves high technical excellence.

The company is exposed to several major risks. One of these is the fact that a major part of their revenue comes from US government hence, if they switch to competitors, the company will have to bear huge losses. In addition to this, the company s marginal revenues are highly dependent upon their operational efficiency of providing the required services to the customers on time. Furthermore, the heavy investment in technology does not always ensure that they will be able to invent or introduce a product that will guarantee success a research can go futile as well. Most importantly, economic recession and inflation can adversely affect their operational efficiency because they require intense sophistication in their technology which obviously requires huge investment.

This thorough analysis of the nature of their business helps to identify that, though the fixed costs are high, its revenue is consistent because of high switching cost for customers. Another aspect is the company s beta is 1.2 according to Google Finance (Google, 2010b), which shows that even if the management plans to have more debt, they will be able to enjoy financial leverage. High debt ratio will also allow them to have greater financial leverage and in turn greater return on investment (Shapiro  Balbirer, 2003, p. 470). Moreover, debt financing will enable them to save taxes on interest payments. On the contrary, in equity financing, along with diluted management, the company will have to pay dividends which are not tax deductible.

Dell Inc.
The second company chosen for discussion is Dell, which offers a wide variety of products and services that include desktop PCs, notebooks, software, networking services, and storage. They are the largest supplier of computer systems and related services in the United States and second largest in the world (Dell Inc., 2009). The nature of their business is characterized by huge fixed costs due to the highly sophisticated machines and equipment for research and development to meet ever rising customer demands for better and more advanced technology. Their target market includes both households and businesses, obviously with varied needs.

Despite having such a wide customer base, Dell has to face immense threats from competition. Although new entrants might not be able to combat a huge giant like Dell, existing players in the market pose great risks. The simple reason behind this high risk factor is the customer s low switching cost. Since there are huge brands in the market, the customers are given with a wide choice of opting for the one which can provide them with the most advanced technology in the lowest price possible. Moreover, if Dell is unable to keep its RD abreast of the latest technology, their market share will easily be wiped out by the competitors. Thus, they have to bear huge fixed costs in order to survive in this industry. Along with achieving technical excellence, Dell will also have to penetrate into newer geographical regions so that they can keep their profitability high by focusing more on turnover instead of profit margin.

Dell s stock has a beta of 1.33 (Google, 2010a) which shows that stock is considered a riskier investment. At this point, it is also important to identify the major risks that the company is exposed to. One of these is the instability in economy and finical markets which can adversely affect their revenue generation and in turn reduce their ability to cover expenses for RD. The company is also exposed to extremely intense competition and exchange rate risk because of its overseas operations. Lastly, due to inevitable requirements of huge investment in technology and equipments, the company relies upon debt financing to a large extent, which in current economic conditions poses great risk for the company s overall performance.

After having analyzed different aspects of the company, I believe that Dell should keep its debt ratio low to medium, primarily. First, the switching cost for customers is very low because competitors are offering equally good product and services at better prices. Second, their immense dependence upon debt can result in deteriorating return on investment particularly when inflation rate goes up. Third, by having a medium to low debt ratio, they will be able to increase shareholder confidence in their shares by decreasing the volatility of their share with respect to the market.

Sprint Nextel Corporation
The third company chosen for this discussion is Sprint Nextel Corporation, a very strong player in the telecommunication industry. It provides wireless and wire line communication services all over the United States. The company has wide wireless network technology which enables them to provide services to customers in various regions. The nature of the business in this industry is characterized by high fixed cost in the shape of licensing, construction and acquisitions of wireless operations and spectrum configuration costs (Sprint Nextel, 2009). The customers for the company are both households and businesses. With the presence of Verizon and ATT, the switching cost for household customers is low. However, for businesses, switching would mean a change in the entire technical network of the company therefore, they might not switch as easily. Although customers are price sensitive, for Sprint Nextel s customer base, quality of communications services, network reliability, and coverage are also important factors which affect customers  choice of service.

The competitor analysis makes it evident that because of extremely high investment, new entrants do not pose much threat. Neertheless, current giant competitors are great threats in terms of greater technological advancements and wider network coverage, achieving economies of scale and lower charges for services. Apart from this, the penetration cost for telecommunication industry is very high because of investment in networks and operational facilities (Sprint Nextel, 2009). Therefore, competitors compete fiercely to retain their current customers.

The stock s beta is 1.27 (Google, 2010c) which displays that the shareholders are of view that the stock is volatile and investment risk is a bit higher. The main risks which their business is exposed to include the consistent technological changes in the telecommunication industry, which means that they have to constantly inject money to achieve technological advancements. If they do not invest money, they are at a risk of losing subscribers to competitors who would offer them more advanced services. The cost of doing business in telecommunication business is high because they cannot derive profits in the shape of profit margins but by increased customer traffic, or in other words, more subscribers. Hence, poor economic conditions do not only affect their subscriber growth rate but also their operational efficiency. Lastly, the company is also exposed to financial risk for not being able to meet the obligations, which in turn increases the cost of equity for the company (Shapiro  Balbirer, 2003, p. 472).

From the information above, I believe Sprint Nextel should maintain medium debt ratio so that they do not expose themselves to high risks of bankruptcy primarily because the switching cost for customers is low. Hence, if the revenues will fall, the company might not be able to meet its obligations. Moreover, medium debt financing will help the company secure its position in current economic conditions when access to financial markets is becoming difficult day by day.