Factors affecting target capital structure

For the establishment of a target capital structure, the firm analyzes certain factors such as; mix of debt, preferred stock and common equity. The specific capital structure changes according to the conditions. The change in capital structure occurs due to the debt ratio. If the debt ratio is below the target level, the debt should be issued to raise the capital.

The firm in its structure policy involves a balance between risk and return in order to achieve the best combination to maximize the firm’s value. The factors which influence capital structure decisions are:

  1. Business risk
  2. The firm’s tax position
  3. Financial flexibility
  4. Managerial conservatism or aggressiveness

The above four factors largely determine the target capital structure. If no debt is used in the firm’s operations, it is at greater business risk while its favorable debt ratio is lower. If the firm uses the debt, the interest is deducted and the effective cost of the debt is lowered; that is the major reason for using debt in the firm’s capital structure policy. If the firm’s income is shattered from certain taxes such as; depreciation tax shields, interest on currently outstanding debt, then tax loss carry-forwards. In such conditions, the firm’s tax rate remains low and additional debt is not as advantageous as with a higher effective tax rate.

In adverse conditions the firm raises the capital on reasonable terms as steady supply of the capital is necessary for long run success. It is in the knowledge of treasurer that at the time of tight economy or operating difficulties the suppliers of capital provides the funds with strong financial statements. Therefore it is observed that need for funds and the results of the fund shortage influence the capital structure. Hence, if the future need for capital is greater the consequences of capital shortage become worse. Therefore the financial statements should be stronger.

The managerial conservatism or aggressiveness also influences the capital structure. Managers of different firms possess different nature and observations or approaches for example some are aggressive than others and few are inclined to use the debt to get more profits. Though this factor is ineffective in maximizing capital structure, yet it has great influence on the managerial target capital structure.

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3 responses to Factors affecting target capital structure

does it mean that, the changes of capital structure in a firm is determine by the business risk, firm’s tax position, financial flexibility, and managerial conservatism or aggressiveness? can this be come out with a regresionnal equation?

Yes, since capital structure is largely dependent upon these four factors therefore, in a regression equation capital structure could be dependent variable whereas business risk, firms tax position, financial flexibility, and managerial conservatism could be independent variables.

I am in the 12th grade and am studying business studies as a subject. In my book, the following has been given under ‘Factors affecting capital structure-Tax Rate’:
” Interest on tax is a tax deductible expense. So, cost of debt is affected by tax rate, e.g., borrowing@10% and the tax rate @ 30%, means the after tax cost of debt is only 7%.
Suppose, 10% debentures Rs 1,00,000 & tax payable @ 30%.
Profit before interest and tax=100000
less: interest (10% of 100000)=10,000
Profit before tax=90,000
Therefore, tax=30% of 90,000=Rs 27,000
If there is no debt, tax=30,000
Tax savings=3,000
So, net interest payable=7,000 which is 7% of Rs 1,00,000.”
I am not able to follow ANY of it..

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