Important Considerations in Determining Capital Structure of a Company

The determination of capital structure involves additional considerations in addition to the concerns about EPS, value and cash flow. A firm may have enough debt servicing ability but it may not have assets to offer as collateral. Some of the most important considerations are discussed below:

1. Assets – The form of assets held by a company are important determinants of its capital structure. Tangible fixed assets serve as collateral to debt. In the event of financial distress, the lenders can access these assets and liquidate them to realize funds lent by them. Companies with higher tangible fixed assets will have less expected costs of financial distress and hence, higher debt ratios. Companies have intangible assets in the form of human capital, relations with stakeholders, brands, reputation etc., and their values start eroding as the firm faces financial difficulties and its financial risk increases.

2. Growth Opportunities – The nature of growth opportunities has an important influence on a firm’s financial leverage. Firm’s with high market-to-book value ratios have high growth opportunities. A substantial part of the value for these companies comes from organizational or intangible assets. These firms have a lot of investment opportunities. High growth firms would prefer to take debts with lower maturities to keep interest rates down and to retain the financial flexibility since their performance can change unexpectedly any time. Mature firms have tangible assets and stable profits. They have low costs of financial distress. Hence, these firms would raise debt with longer maturities as the interest rates will not be high for them and they have a lesser need of financial flexibility since their fortunes are not expected to shift suddenly.

3. Debt and Non-Debt Tax Shields- Debt, due to interest deductibility, reduces the tax liability and increases the firm’s after-tax free cash flows. In the absence of personal taxes, the interest tax shields increase the value of the firm. Generally, investors pay taxes on interest income but not on equity income. Hence, personal taxes reduce the tax advantage of debt over equity. The tax advantage of debt implies that firms will employ more debt to reduce tax liabilities and increase value. Firms also have non-debt tax shields available to them. For example, firms can use depreciation; carry forward losses etc. to shield taxes. This implies that those firms that have larger non-debt tax shields would employ low debt, as they may not have sufficient taxable profit available to have the benefit of interest deductibility.

4. Financial Flexibility and Operating Strategy- A cash flow analysis might indicate that a firm could carry high level of debt without much threat of insolvency. But in practice, the firm may still make conservative use of debt since the future is uncertain and it is difficult to be able to consider all possible scenarios of adversity. It is, therefore, prudent to maintain financial flexibility that enables the firm to adjust to any change in the future events or forecasting error.

Financial flexibility is a serious consideration in setting up the capital structure policy. Financial flexibility means a company’s ability to adapt its capital structure to the needs of the changing conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure as warranted by the company’s operating strategy and needs.

5. Loan Covenants- Restrictive covenants are commonly included in the long-term loan agreements and debentures. Covenants in loan agreements may include restrictions to distribute cash dividends, to incur capital expenditure, to raise additional external finances or to maintain working capital at a particular level. Loan covenants may look quite reasonable from the lender’s point of view as they are meant to protect their interests, but they reduce the flexibility of the borrowing company to operate freely and it may become burdensome if conditions change. Violation of covenants can have serious adverse consequences.

6. Financial Slack- The financial flexibility of a firm depends on the financial slack it maintains. The financial slack includes unused debt capacity, excess liquid assets, underutilized lines of credit and access to various untapped sources of funds. The financial flexibility depends a lot on the company’s debt capacity and unused debt capacity. The higher is the debt capacity of a firm and the higher is the unused debt capacity, the higher will the degree of flexibility enjoyed by the firm. A company should not borrow to the limit of its capacity, but keep available some unused capacity to raise funds in the future to meet some sudden demand for finances.

7. Sustainability and Feasibility- The financing policy of a firm should be sustainable and feasible in the long run. The sustainability model growth helps to analyse the sustainability and the feasibility of the long-term financial plans in achieving growth. Given the firm’s financing and payout policies and operating efficiency, this model implies that its assets and sales will grow in tandem with growth equity (internal). Thus, the sustainable growth depends on return on equity (ROE) and retention ratio:

Sustainable growth = ROE * (1-payout)

The sustainable growth model indicates the growth rate that the firm should target. In fact, the model also indicates the trade-offs between the financing and operating policies. The firm must realize that growth does not ensure value creation. The firm should also examine the impact of alternative financial policy on the value of the firm.

8. Control- In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. This is particularly so in the case of the firms promoted by entrepreneurs. The existing management team not only wants control and ownership but also to manage the company, without any outside interference.

9. Capacity of Raising Funds- The size of a company may influence its capital structure and availability of funds from different sources. A small company finds great difficulties in raising long-term loans. A large company has relative flexibility in designing its capital structure. It can obtain loans on easy terms and sell ordinary shares, preference shares and debentures to the public. The size of the firm has an influence on the amount and the cost of funds, but it does not determine the pattern of financing.

10. Issue Costs- Issue or flotation costs are incurred when the funds are externally raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage company’s to use debt than issue equity shares. Large firms require large amounts of funds, and they may plan large issues of securities to economize on the issue costs. The company should raise only that much of funds, which it can employ profitably.

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