According to the stern.nyu.edu January 2019 dataset, the average percentage of debt financing of the firms listed was 42%. I selected the Retail (Grocery and Food) industry which has a debt financing percentage of 45.48% and the Rubber& Tires industry, which has a debt financing percentage of 54.47% to represent firms with a higher than average debt financing ratio and the Software (System & Application) and Semiconductor industries with debt financing percentages of 11.4% and 12.39% respectively to represent firms with a below average debt financing percentage (Damodaran, 2019).

When considering the amount of debt to include in the capital structure, the optimal amount of debt is when the marginal tax benefit of debt equals the marginal distress costs of debt (Ross, Westerfield, & Jaffe, 2013). Although more debt would lower the cost of capital, another aspect of debt financing is the marginal distress costs of debt or the cost of financial distress (Ross, Westerfield, & Jaffe, 2013). As the amount of debt increases, the liabilities attributed to the fixed cost of debt (interest expense) and risk of defaulting on the debt also increase (Ross, Westerfield, & Jaffe, 2013). Two aspects to consider when evaluating a firm's ability to meet its debt obligation are the firm's asset mix and volatility of the firm's operating income (Ross, Westerfield, & Jaffe, 2013).

Firms that operate with an asset mix consisting of a higher percentage of tangible assets, versus an asset mix consisting of research and development, are better prepared to meet its obligations to its bondholders in the wake of bankruptcy, as the value of research and development is diminished during times of financial distress (Ross, Westerfield, & Jaffe, 2013). Therefore, firms with a higher percentage of tangible assets can maintain higher levels of debt in their capital structure. When comparing the selected industries, the Rubber & Tire and Retail food industries are not as likely to invest as heavily in research and development as firms in the software and semiconductor industries. Their asset mix likely contains a higher percentage of tangible assets (facilities, etc.) which can explain the higher than average debt financing percentage.

Additionally, volatility in the market impacts financial distress. Volatility in the market directly impacts a firm's operating income as the ability to meet the financial obligations to its creditors is also predicated on the firm's cashflows (Ross, Westerfield, & Jaffe, 2013). When reviewing the betas of the selected firms, the betas for the Retail (Grocery and Food) and the Rubber& Tires industries were .42 and .45 respectively and 1.23 and 1.34 respectively for the Software (System & Application) and Semiconductor industries (Damodaran, 2019). The betas less than one indicate industry performance is less volatile and more stable with relation to market shifts. The industries with betas greater than one indicate the industry performance is more volatile than the market. The increased volatility therefore increases financial distress as the risk of not meeting its obligations to creditors in low times are higher, therefore the firm should not carry as much debt in its capital structure (Ross, Westerfield, & Jaffe, 2013).

References

Damodaran, A. (2019). Cost of Capital by Sector (US). Retrieved February 21, 2019 from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/wacc.htm (Links to an external site.)

Ross, S., Westerfield, R., & Jaffe, J. (2013).Corporate finance(10th ed.). New York, NY: McGraw-Hill/Irwin.

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