648  Capital Structure, Dividends, and Share Repurchases above $350 billion. One possible explanation: larger companies are more likely to diversify their risk. The second indicator is coverage in terms of EBITA or EBITDA relative to interest expense or debt, defined as follows: Debt Coverage Net Debt EBITA or Net Debt EBITDA Interest Coverage E = = BITA Interest or EBITDA Interest A similar indicator that is widely used by credit analysts is based on so-called free flow from operations (FFO) instead of EBITA or EBITDA. FFO is defined as EBITDA minus interest and tax charges. Coverage is more relevant than size when you are setting a capital struc- ture target. Basically, it represents a company’s ability to comply with its debt service obligations. For example, EBITA interest coverage measures how many times a company could pay its interest commitments out of its pretax operational cash flow if it invested only an amount equal to its annual depre- ciation charges to keep the business running (or, for EBITDA coverage, if it invested nothing at all). In today’s low-interest-rate environment, however, debt coverage is a better measure of a company’s long-term ability to service its debt. Interest coverage ratios might appear strong today for some compa- nies simply because they attracted debt at low interest rates over the past few years. When these companies need to re-fund the debt at higher rates in the future, their interest coverage will plummet. Exhibit 33.8 shows how interest coverage and debt coverage explain rating differences for a sample of large U.S. companies rated by Standard & Poor’s (excluding financial institutions). Obviously, we could further refine the anal- ysis by including more explanatory ratios, such as free flow from operations (FFO) to interest, solvency, and more. However, these ratios are often highly correlated, so calculating them does not always produce a clearer explanation. For a given credit rating, the coverage will typically differ by industry (see Exhibit 33.9). This is because of differences in underlying business risk. Com- panies in industries with more volatile earnings need higher coverage to at- tain a given credit rating, because their cash flow is more likely to fall short of their interest commitments.27 For example, companies in basic materials—say, steel companies—will need higher levels of interest coverage than food and beverage companies to attain the same credit rating. By taking into account these differences in coverage requirements across industries, we can translate a company’s targeted credit rating into a target coverage ratio. Based on the company’s estimated future operating profit (and interest rate), we can derive 27 Earnings volatility is measured here as the average standard deviation of relative annual changes in EBITDA for companies in each sector. SettinG a tarGet Capital StruCture 649 its maximum debt capacity for the chosen credit rating and, thereby, its target capital structure. For example, companies aiming for an investment-grade rat- ing in the food and beverage sector would typically need to have an EBITDA- to-interest ratio of around 5 or better. Given projections of near-term EBITDA and interest rates, you can derive a fi rst estimate of the target amount of net debt for such a company to reach an investment-grade rating. A defi nitive rating estimate would require more in-depth analysis of specific financial and business risks that the company is facing. A place to start is, for example, with the websites for Standard & Poor’s ( www.spratings.com ) or Moody’s ( www.moodys.com ). It is important to compare a target capital structure for a company against that of its industry peer group. The key determinants of value trade-offs in designing capital structure—growth, return, and asset specifi city—are largely industry specifi c, so any large differences in capital structure would require further investigation. It also makes sense from a competitive perspective: as long as your capital structure is not too different, you have at least not given away any competitive advantage derived from capital structure (nor have you gained any). 28 Since the 1960s, a body of evidence has built up showing EXHIBIT  33.8 Credit Rating vs. Interest and Debt Coverage 60 50 40 30 20 Interest coverage1 10 0 AAA, AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B B+ B– CCC+ Credit Rating 14 12 10 8 6 4 Debt coverage1 2 0 AAA, AA+ AA AA– A+ A A– BBB+ BBB BBB– BB+ BB BB– B B+ B– CCC+ Credit Rating Median 3rd quartile 1st quartile Estimated 1 EBITDA/interest. EBITDA is earnings before interest, taxes, depreciation, and amortization. 2 Net debt/EBITDA. Source: S&P Capital IQ; Corporate Performance Analytics by McKinsey. 28 For example, there is academic evidence that high-leverage companies sometimes fall victim to price wars started by fi nancially stronger competitors. See P. Bolton and D. Scharfstein, “A Theory of Preda- tion Based on Agency Problems in Financial Contracting,” American Economic Review 80, no. 1 (1990): 93–106.