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The primary factors that influence a company's capital-structure decision are:
1. Business Risk:
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio. As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.
2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has. The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).5. Growth RateFirms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.6. Market ConditionsMarket conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
Some other factors which are also responsible to influence a company's capital-structure decision are as follows:
(1) Cash Flow Position.
(2) Interest Coverage Ratio-ICR.
(3) Debt Service Coverage Ratio-DSCR.
(4) Return on Investment-ROI.
(5) Cost of Debt.
(6) Tax Rate.
(7) Cost of Equity Capital.
(8) Floatation Costs.
(9) Risk Consideration.
There are two types of risks in business:
(i) Operating Risk or Business Risk.
(ii) Financial Risk.
(10) Flexibility.
(11) Control.
(12) Regulatory Framework.
(13) Stock Market Conditions.
The attitude of management, and what if it is aggressive(Debt) or conservative(equity), the growth rate of the company (rapid-debt / slow-equity), The risk of the company field (high-debt / low- equity), the tax rate(high-debt / low-equity) and the stability of the company (high-equity / low-debt)
FACTORS THAT INFLUENCE A COMPANY'S CAPITAL-STRUCTURE DECISION:
The capital structure of a company is a particular combination of debt, equity and other sources of finance that it uses to fund its long-term asset. The key division in capital structure is between debt and equity. The proportion of debt funding is measured by gearing or leverages. There are different factors that affect a firm's capital structure, and a firm should attempt to determine what its optimal or best mix of financing.
The firm’s size has been the critical point of capital structure decision. The larger companies have more access to funds and less chances of default that’s why they enjoy more borrowings as compare to smaller firms.
Some of the chief factors affecting the choice of the capital structure are the following:
CASH FLOW POSITION:
While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.
COST OF DEBT:
The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilized and vice versa.
TAX RATE:
The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of ‘interest on the debt capital’ from the profits considering it a part of expenses and a saving in taxes.
COST OF EQUITY CAPITAL:
Cost of equity capital (the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilized more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.
FLOATATION COSTS:
Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital. This attracts the company towards debt capital.
OPERATING RISK OR BUSINESS RISK:
This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc),
FINANCIAL RISK:
This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company.
If the operating risk in business is less, the financial risk can be faced i.e., more debt capital can be utilized. If the operating risk is high, the financial risk should be avoided.
FLEXIBILITY:
Capital structure should be fairly flexible. Flexibility means that amount of capital in the business could be increased or decreased easily. Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.
If at any given time company has more capital than necessary then both the above-mentioned capitals can be repaid. On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility, issuing debt capital and preference share capital is the best.
CONTROL:
At the time of preparing capital structure, it should be ensured that the control of the existing shareholders (owners) over the affairs of the company is not adversely affected.
If funds are raised by issuing equity shares, then the number of company’s shareholders will be increased and it directly affects the control of existing shareholders. In other words, now the number of owners (shareholders) controlling the company are increased. This situation will not be acceptable to the existing shareholders. Contrariwise, when funds are raised through debt capital, there is no effect on the control of the company because the debenture holders have no control over the affairs of the company. Thus, for those who support this principle debt capital is the best.
REGULATORY FRAMEWORK:
Capital structure is also influenced by government regulations such as it may be compulsory for companies to maintain a given debt-equity ratio while raising funds.
STOCK MARKET CONDITIONS:
Stock market conditions refer to upward or downward trends in capital market. Both these conditions have their influence on the selection of sources of finance. When the market is dull, investors are mostly afraid of investing in the share capital due to high risk.
On the contrary, when conditions in the capital market are cheerful, they treat investment in the share capital as the best choice to reap profits. Companies should, therefore, make selection of capital sources keeping in view the conditions prevailing in the capital market.
CAPITAL STRUCTURE OF OTHER COMPANIES IN THE SAME INDUSTRY:
Capital structure is influenced by the industry to which a company is related. All companies related to a given industry produce almost similar products, their costs of production are similar, they depend on identical technology, they have similar profitability, and hence the pattern of their capital structure is almost similar.
In my opinion the factors more important in the determination of capital structure could be:
Financial Flexibility, Growth Rate, Business Risk, Company's Tax Exposure, Market Conditions and Management Style.
According to my point of view it totally depends on the management deision that Are they risk taker or risk averse? If they are aggressive they can go for60/40 or even70/30 ratio of debt to equity. if they presume that growth is high they should go for high debt in capital structure.
- weighted average cost of capital, tax consideration, financial leverage, operating leverage, risk appetite,
