Importance of Capital Structure Planning

For the real growth of the company the financial manager of the company should plan an optimum capital structure for the company. The optimum capital structure is one that maximize the market value of the firm. In practice the determination of the optimum capital structure is a formidable task and the manager has to perform this task properly, so that the ultimate objective of the firm can be achieved.

There are significant variations among industries and companies within an industry in terms of capital structure. Since a number of factors influence the capital structure decision of a company, the judgment of the person making the capital structure decisions play a crucial part. A totally theoretical model can’t adequately handle all those factors, which affects the capital structure decision in practice. These factors are highly psychological, complex and qualitative and do not always follow accepted theory, since capital markets are not perfect and decision has to be taken under imperfect knowledge and risk.

An appropriate capital structure or target capital structure can be developed only when all those factors, which are relevant to the company’s capital structure decision, are properly analyzed and balanced. The capital structure should be planed generally keeping in view the interest of the equity shareholders and financial requirements of the company. The equity shareholders being the owner of the company and the providers of risk capital (equity), would be concerned about the ways of financing a company’s operations. However, the interest of other groups, such as employee, customers, creditors, society and government, should be given reasonable consideration when the company lays down its objective in terms of the shareholders wealth maximization,   it is generally compatible with the interest of other groups. Thus, while developing an appropriate capital structure for a company the finance manager should inter alia aim at maximizing the long-term market price per share. Theoretically, there may be precise point or range within which the market value per shares is maximum. In practice, for most companies within an industry there may be a range within which there would not be great differences in the market value per share. One way to get an idea of this range is to observe the capital structure patterns of companies vis-a-vis their market prices of share. The management of companies may fix its capital structure near the top of this range in order to make maximum use of favorable leverage, subject to other requirements such as flexibility, solvency, control and norms set by the financial institutions – The Securities and Exchange Board of India (SEBI) and Stock Exchanges.

Guidelines for Capital Structure Planning

The following are the guidelines of capital structure planning:

1)     Avail or Tax advantage of Debt

Interest on debt finance is a tax-deductible expense. Hence, finance scholars and practitioners agree that debt financing gives rise to tax shelter which enhances the value of the firm. What is the impact of this tax shelter on the value of the firm? In this 1963 paper Modigilani and Miller argued that the present value of the interest tax shield is – tcD  where, tc = corporate tax rate on a unit of marginal earnings and D = Debt financing.

2)     Preserve Flexibility

The tax advantage of debt should not persuade one to believe that a company should exploit its debt capacity fully. By doing so, it loses flexibility. And loss of flexibility can erode shareholder value. Flexibility implies that the firm maintains reserve borrowing power to enable it to raise debt capital to respond to unforeseen changes in government policies, recessionary conditions in the market place, disruption in supplies, decline in production caused by power shortage or labor market, intensification in competition, and, perhaps most importantly, emergence of profitable investment opportunities. Flexibility is a powerful defense against financial distress and its consequences which may include bankruptcy.

3)     Ensure that the Total Risk Exposure is Reasonable

While examining risk from the point of view of the investor, a distinction is made between systematic risk (also referred to as the market risk or non-diversifiable risk) and unsystematic risk (also referred to as the non-market risk or diversifiable risk).

Business Risk refers to the variability of earnings before interest and taxes. It is influenced by the following factors:

  • Demand Variability- Other things being equal, the higher the variability of demand for the products manufactured by the firm, the higher is its business risk.
  • Price Variability- A firm which is exposed to a higher degree of volatility in the prices of its products is, in general, characterized by a higher degree of business risk in comparison with similar firms which are exposed to a lesser degree of volatility in the prices of their products.
  • Variability in Input Prices- When input prices are highly variable, business risk tends to be high.

4)     Subordinate Financial Policy to Corporate Strategy

Financial Policy and Corporate Strategy are often not integrated well. This may be because financial policy originates in the capital market and corporate strategy in the product market.

5)     Mitigate Potential agency Costs

Due to separation of ownership and control in modern corporations, agency problems arise. Shareholders scattered and dispersed as they are not able to organize themselves effectively. Since agency costs are borne by shareholders and the management, the financial strategy of a firm should seek to minimize these costs. One way to minimize agency costs is to employ an external agent who specializes in low cost monitoring. Such an agent may be a lending organization like a commercial bank (or a term-lending institution).

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