Question

what do you think are the most important qualitative and Quantitative factors that enter in to the capital structure decision process! Explain your answer and provide an example to support your reasoning.

Answer 1

A. Qualitative factors that enter into capital structure decision process:

1. Business risk:

Business risk is the main risk of the company’s operations apart from the debt. The business and the debt are inversely related to each other. The greater the business risk, the lower is the optimal debt ratio. The business risk factor will have a great influence in the capital decision process of a company by keeping the company competitive in the market.

Example: Let’s take a utility company and an apparel company. The earnings for utility company is stable as we use that things in our regular life. So, the utility company will have less business risk. But, in case of an apparel company, the earnings are more variable (not stable) because of the trends in the fashion industry and the tastes and preferences of the consumers. Therefore, the risk of apparel company in its business is high.

2. Management:

Management of a company plays a vital role in the capital structure decision of a company. The management decision ranges from conservative to aggressive.

For example, if a management’s approach is more conservative, the less is the use of debt to increase the business profits. If a management’s approach is more aggressive, the more is the use of the debts to grow the business quickly and increase profits thereby increasing the earnings per share.

3. Market conditions:

Market conditions have a significant influence on the capital structure decision process of a company. It is easy and beneficial for a company to raise funds if the market conditions are favourable.

For example, a company wants to raise funds from the market for the purpose of acquiring new pant & machinery. If the investors are limiting the companies’ access to borrow funds because of some market concerns, the company has to pay a higher interest rate than desired/optimal in case if it wants to raise funds. Otherwise, it should wait until the market conditions return to normal position and raise the funds. This leads to delay in acquiring the new plant & machinery to use in business operations and the company may lose the competitive advantage.

B. Qualitative factors that enter into capital structure decision process:

1. Financial flexibility:

Financial flexibility means the company’s ability to raise funds in bad times. A company can easily raise the funds when the sales are more and the earnings are high. So, it is not hard for a company to raise the funds when the financial position is strong and the cash flows are good and vice versa. It is relatively easier to raise the funds when the debt level is low and vice versa.

For example, if we take a resort, in good times it will generate significant amounts of sales and cash flow. But in bad times, the situation is reversed and it will face difficulties to borrow the funds. The investors will limit the company to raise funds as the company is in bad times.

2. Growth rate:

Companies which are in the growth stage borrow funds to grow faster. In this stage, the growing companies’ revenues are unstable. So, raising more funds through debt is not appropriate. On the other side, matured and stable firms needs less funds as they might have already reached a commanding position in the industry and they can generate the sufficient cash flows for their projects.

3. Tax exposure:

A company should consider the debts as a major factor in its capital structure decision process. Debt payments are tax deductible elements. If a company’s tax rate is high, then using of debts to raise funds is attractive because the tax deductibility of debt payments reduces the tax liability.

For example, if the company borrowed $10000000 and the interest rate is 6% (say), then the company will have the benefit of interest paid on the borrowings which will result in the reduction of payment of tax liability.