Question

Establishing a capital structure for a firm is not simple. Although financial theory guides the process, there is no easy formula to determine a target debt-to-equity ratio. However, there are key factors which should be considered as they affect the target ratio.List and explain these factors.

Answer 1

Capital structure decision, in simple, is a decision on debt equity mix in the company.

Optimum debt level in capital structure depends on expectation of shareholder, industry that it caters and risk factors involved. So there is no one single suite for all the companies.

For example- If company has 100M$ equity with no debt and earns 20M$ profits. Return on equity is 20% (20/100). But if company decides to have debt of 50M$ and equity of 50M$. Profit remains around 20M$ itself, then return on equity would be 40% (20/50).

By just changing capital structure shareholder's increased their returns by twice. However, it is a double edge sword. Instead of profit, if it was loss. Then loss would be twice due to changing capital structure. To make it worse you should also pay interest to debt holders.

Now you should be clear on how complicated capital structure decision can get for a company. Key factors are-

1. Financial risk - precisely my explaination above. You should be clear on if you will make profits and repay debt holders.

2. Operational risk- Are you optimally using your assets to achieve operational efficiency to enhance profits. If not, don't take more debt

3. Cost of debt- Interest that needs to be paid to debt holders. If it is excessive then additional ROE made by company using debt will be eroded due to interest cost. It must be optimum based on level of operations.

4. Other factors

a. Tax rate- as you will get tax benefit in interest paid

b. Flotation costs- Cost of taking new debt or issuing new equity.

c. Cost of equity- If you feel issue equity to be suiting your business to reduce debt level

d. Law of the country, political feasibility, Stock market optimism, debt market, etc.