Capital Structure the Three Companies Research Proposal

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The cyclicality of Choice, evidenced by their beta, and the intense competitive pressures, means that the firm is at risk for periods of difficulty. If they are too highly-leveraged, these periods could cause irreparable harm to the company. Ideally, Choice would limit the downside damage caused by the inevitable turbulent times. The medium debt ratio achieves this.

The ideal capital structure for Dell Computers is a high debt ratio. Dell's business is growing. From their beta we can infer that Dell itself is relatively stable, since they have such a broad customer base. They sell to both businesses and consumers, with several of their product lines being business only. Thus, the bulk of their risk is market risk.

The high debt ratio gives Dell sufficient leverage to participate in their industry's growth. Without a strong cyclical downside, they are in a good position to take on a higher debt ratio, since they are unlikely to experience a strongly negative environment. They will, however, have ample opportunities to enter new markets or exploit rapidly growing markets. The result is that Dell stands to reap significant benefits from a high-leverage situation, but does not have much downside volatility.

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The asset beta for Safeway calculates out as 2.063. This reflects a medium to low debt-to-equity ratio of 1.63. Safeway's asset beta evidences a company that has relatively low asset risk, a testament to the stability of their business. This relatively low asset beta is therefore expected.

The asset beta for Dell is high at 5.5058. The main determinant of this high asset beta is the high debt-to-equity ratio of 6.93. Dell is a highly levered firm in a growing industry so the high asset beta is expected. This is indicative of a firm that is operating from a strong financial base in a changing industry where growth opportunities are abundant, thus giving them an incentive to increase their risk.

It is impossible to calculate the asset beta for Choice Hotels. Right now, and for the past several years, CHH has not had equity. They are highly levered, which fits with their strategy of rapid expansion and the tough business environment in which they operate. While they are in a risky financial position, CHH has been able to maintain a relatively stable balance sheet over the past five years.

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