Factors Affecting Capital Structure Decisions

Capital structure decisions are very important for companies to make. But there are always some other factors which firms take into consideration while making capital structure decisions. These factors are given below:

 

Sales Stability:

 

Firms consider this factor at the time of capital structure decisions. For example there are two firms; one having stable sales and other having unstable sales, the firm whose sale is relatively stable can safely take on more debt and incur fixed charge in comparison to the firm with unstable sales. For instance, the utilities companies use more financial leverage than industrial firms because they have stable sales   

 

Operating Structure:

 

This is another factor which is involved in making capital structure decisions. A firm having less operating leverage can imply financial leverage in better way as it will have less business risk.

 

Assets Structure:

 

This factor may affect the capital structure decisions; there are two types of assets which are: general purpose assets and special purpose assets. The real state companies usually use general purpose assets as it makes good collateral. While the companies which are involved in technological research use special purpose assets because they are not highly leveraged.

 

Profitability:

 

The factor of profitability also plays an important role in capital structure decisions. The firms which get high rates of return on investment do not use high debt but they use relatively little debt.  High rates of return on investment make them able to do financing with internally generated funds.

 

Growth Rate:

 

This factor plays an important role in capital structure decision making. It has been observed that faster growing firms mostly rely on external capital as the flotation costs exceeds. It is also possible that the firms relying on external capital may often face greater uncertainty due to which they may reduce their willingness to use debt.

 

Control:

 

there is great affect of control situation on capital structure decisions, because in such a situation management has 50% voting control between the debt and equity. If the management is not in a position to buy or purchase more stock, the other option for it is to use debt for new financing. But in a situation when the firm’s financial position is so week that the use of debt may cause serious risk of default then the control considerations could lead to use either debt or equity.

 

Taxes:

 

As far as interest is concerned it is no doubt a deductible expense which is much valuable to firms with high tax rates. This is the reason that many firms use much debt because if firm’s tax rate is higher the advantage is also greater.

 

Management Attitudes:

 

Different management attitudes may bring different changes in capital structure decisions. Management may be conservatives or aggressive depending upon the attitude towards risk taking. Both managerial styles exercise according to their own judgments and analytical approaches about the proper capital structure. If the management attitude is conservative it uses less debt, where if the management is having aggressive approach then it uses more debt to get higher profits.

 

Lender and Rating Agency Attitudes:

 

Lenders and rating agencies also plays an important role in financial structure decisions. The corporations give much importance to the lenders and rating agencies. They make discussions about the capital structure and mostly act accordingly to their advice.

 

Market Conditions:

 

Capital structure also depends on market conditions; a firm’s optimal capital structure or favorable capital structure depends on long-term and short-term changes. Low rated companies which are in need of capital either go for the stock market or the short-term debt market without taking consideration of target capital structure.

 

Financial Flexibility:

 

financial flexibility has also impact on capital structure decision. A firm or company makes the decision according to its financial flexibility. If a company is financially good it can raise capital with either stock or bond. But when its financial position is week the suppliers of capital make funds available if the company gives them a secure position in shape of debt. Seeking all above thoughts in mind it can be said that the companies should maintain the financial flexibility or adequate reserve borrowing capacity because it depends on the factors which are necessary in making capital structure decisions.

 

Firm’s Internal Conditions:

 

this is also one of the factors which affect the capital structure decisions. If a firm succeeds in completing any project then the probability of higher returns increase in the near future. Due to such internal conditions a company would not issue stock because the new earnings are neither anticipated nor reflected in the stock prices. So in such conditions the company or firm would give preference to finance with debt till the higher earnings are materialized or reflected in the stock prices.      

16 responses to Factors Affecting Capital Structure Decisions

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1. How do capital structure,finacing,investing and other decisions affect a firm’s values?
2. What are the factors that influence these decisions?

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