The Credit Markets and Company Liquidity
Jim Graham

Troubles in the credit markets have been the main theme of the financial news lately.  What began as difficulties with sub-prime mortgage loans, and other debt instruments related to them, has spread to other sections of the credit markets.  Firms in the finance and banking sectors are having problems, with the dramatic downfall of investment bank Bear Stearns the most recent sign that the problems are not over. 

The Federal Reserve has moved aggressively to lower interest rates and taken unprecedented steps to inject additional liquidity into the markets in an attempt to prevent these problems from spilling over into the general economy.  In some ways this already failed, since the economy has definitely slowed.  Thus far the damage has been confined to financial firms that are directly impacted by problems in the credit markets. 

The main mechanism by which these problems can affect the "real" economy is by reducing the amount of credit available to firms.  Financial firms have had to write off billions of dollars in investments, and banks have been busy shoring up their balance sheets by getting fresh equity investments.  As they try to conserve cash and improve their balance sheets, banks and financial firms then become more reluctant to lend and may also call in some loans to raise cash.

The Financing of a Firm: Debt vs. Equity

Economic theory says that the mix of debt and equity in a company's capital structure is irrelevant and that the value of a firm is independent of its debt ratio.  In finance, capital structure refers to the way a company finances its assets through a combination of debt and equity.  In the real world, companies and investors have to worry about things like taxes and the default, so a company's capital structure is relevant to long-term survival.

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