Posted by mbalectures | Posted in Introduction to Finance | 12,012 views | Posted on 10-01-2011 |
Tagged Under : capital structure, capital structure choice, choice of debt or equity, choice of selecting capital structure, debt or equity, factors affecting choice of debt, factors affecting choice of equity, factors affecting the choice of capital structure, Factors affecting the choice of debt or equity
The choice of debt or equity for the funds is observed as one of the crucial issues for the management in the organization. There are different factors which plays an important role in the choice of capital structure. All the firms must consider such factors in forming a decision regarding the capital structure. These factors are given below:
Firms consider sales stability at the time when they select a debt or equity to generate the funds. Firms with the stable sales took more debt and incur fixed charge as compared to the firms with unstable sales. It is observed that utilities companies choose more debt as compared to the industrial firms because the utilities firms have more sales stability.
Asset structure also affects the choice of capital structure. There are two types of assets which are: general purpose assets and special purpose assets. Generally, the real state companies uses the general purpose assets as these can make good collateral. Therefore, they are highly leveraged. Whereas the companies involved in the technological research uses special purpose assets. Such companies are not highly leveraged.
It is considered as one of the important factor in the choice of debt or equity for generation of funds. It is observed that firms with high return on investment usually avoid using more debt because firms with high profitability finance through internally generated funds. The debt to equity ratio increases if the expected returns of firm increases and there is positive relationship between debt to equity ratio and returns of firm. Similarly, profitability is also significant determinant of capital structure. Profitability has the positive effect on leverage when it is measured as operating income divided by total sale and it has negative effect when it measured as operating income divided by total assets.
Control situation also affects the choice of debt or equity. Situation in which management possesses 50% voting control can decide to issue debt in case the firm is not in position to issue more stocks. On the other hand in a situation where the debt may cause a default then the firms have a choice to choose any one of these (debt or equity).
Taxes are deductable expenses. It is therefore favorable for the firms with high tax rates to have high debts because the debts will ultimately reduce the burden of taxes. In such a scenario, advantages are greater for firms which decide to move to debt if the tax rate is higher.
Growth rate also plays an important role in selection of capital structure. Usually, it is observed that firms with high growth rate frequently rely on the external financing as the flotation costs increase with the issuance of debts. This is the rationale that rapidly growing firms rely more on debt rather than equity. On the other hand, there is possibility that even with higher growth rate firms may not rely on debt because firms often face greater uncertainty.
This is also an important factor of the choice of capital structure. Firms with less operating leverage are in a better position because there is less business risk. On the other hand firms with high operating leverage face difficulties due to higher risk.
Management attitude has a greater influence in the choice of capital structure. Management is either conservative or aggressive. Both the management styles are according to judgments and analytical approaches. On the basis of calculations and approaches, decisions are taken regarding capital structure. It is observed that firms with conservative managerial style uses less debt and preferred internal funds or issued equity. On the other hand, firms with aggressive managerial style use more debt and less equity in order to get higher profits.
Firm’s Internal Conditions
The capital structure decisions are also affected by firm’s internal conditions. When the firm succeeds to accomplish its targets or any healthy project, it is anticipated that the returns will increase in the near future. In such conditions, firms do not issue equity because new earnings are not reflected in the stock prices. Firms prefer to finance with debt and the higher earnings are materialized and reflected in the stock prices.
Capital structure is also dependent on the financial flexibility. When the company is financially strong it enhances capital either from debt or equity but if the firm’s financial position is not strong then the firm issues debt.
Lender and rating agency attitudes
Lender and rating agency also plays a vital role in the selection of capital structure. Firms conduct discussions with lender and agencies regarding choice of capital structure. They generally act according to advices of Lender and rating agencies.
Market conditions also have an impact on capital structure. Selection of capital structure depends on the long term and short term changes in market. Low rated firms either decide to issue securities or short term debt to finance its projects without considering target capital structure. Usually firm’s use both types of debt i.e. short term debt as well as long term debt to balance the leverage but it observed that long term debts are used more.
It is observed through many studies that prices have an impact on capital structure. Stock prices play a vital role in shaping a firm’s financing choice. Firms with large stock price are expected to issue equity and retire debt than firms that experience stock price reductions.