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The primary factors that influence a company's capital-structure decision are:
1. Business Risk
2. Company's Tax Exposure
3. Financial Flexibility
4. Management Style
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 primary factors that influence a company's financial structures 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 FlexibilityThis 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).
