Question

1. What are some factors that affect capital structure decisions made by management? What are the arguments in support of using debt as part of the capital structure?

2. Does capital structure influence the value of a firm? Why or why not?

Answer 1

1. Factors that affect capital structure decisions made by management are as follows:

a. Cash Flow Position:

The decision related to composition of capital structure also depends upon the ability of business to generate enough cash flow.The company is under legal obligation to pay a fixed rate of interest to debenture holders, dividend to preference shares and principal and interest amount for loan. Sometimes company makes sufficient profit but it is not able to generate cash inflow for making payments.The expected cash flow must match with the obligation of making payments because if company fails to make fixed payment it may face insolvency. Before including the debt in capital structure company must analyse properly the liquidity of its working capital.A company employs more of debt securities in its capital structure if company is sure of generating enough cash inflow whereas if there is shortage of cash then it must employ more of equity in its capital structure as there is no liability of company to pay its equity shareholders.

b. Interest Coverage Ratio (ICR):

It refers to number of time companies earnings before interest and taxes (EBIT) cover the interest payment obligation.

ICR= EBIT/ Interest

High ICR means companies can have more of borrowed fund securities whereas lower ICR means less borrowed fund securities.

c. Debt Service Coverage Ratio (DSCR):

It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but DSCR takes care of return of interest as well as principal repayment.

If DSCR is high then company can have more debt in capital structure as high DSCR indicates ability of company to repay its debt but if DSCR is less then company must avoid debt and depend upon equity capital only.

d. Return on Investment:

Return on investment is another crucial factor which helps in deciding the capital structure. If return on investment is more than rate of interest then company must prefer debt in its capital structure whereas if return on investment is less than rate of interest to be paid on debt, then company should avoid debt and rely on equity capital. This point is explained earlier also in financial gearing by giving examples.

e. Cost of Debt:

If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as compared to equity.

f. Tax Rate:

High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from income before calculating tax whereas companies have to pay tax on dividend paid to shareholders. So high end tax rate means prefer debt whereas at low tax rate we can prefer equity in capital structure.

g. Cost of Equity:

Another factor which helps in deciding capital structure is cost of equity. Owners or equity shareholders expect a return on their investment i.e., earning per share. As far as debt is increasing earnings per share (EPS), then we can include it in capital structure but when EPS starts decreasing with inclusion of debt then we must depend upon equity share capital only.

h. Floatation Costs:

Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost of advertisement, underwriting statutory fees etc. It is a major consideration for small companies but even large companies cannot ignore this factor because along with cost there are many legal formalities to be completed before entering into capital market. Issue of shares, debentures requires more formalities as well as more floatation cost. Whereas there is less cost involved in raising capital by loans or advances.

i. Risk Consideration:

Financial risk refers to a position when a company is unable to meet its fixed financial charges such as interest, preference dividend, payment to creditors etc. Apart from financial risk business has some operating risk also. It depends upon operating cost; higher operating cost means higher business risk. The total risk depends upon both financial as well as business risk.If firm’s business risk is low then it can raise more capital by issue of debt securities whereas at the time of high business risk it should depend upon equity.

j. Flexibility:

Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances.

k. Control:

The equity shareholders are considered as the owners of the company and they have complete control over the company. They take all the important decisions for managing the company. The debenture holders have no say in the management and preference shareholders have limited right to vote in the annual general meeting. So the total control of the company lies in the hands of equity shareholders.If the owners and existing shareholders want to have complete control over the company, they must employ more of debt securities in the capital structure because if more of equity shares are issued then another shareholder or a group of shareholders may purchase many shares and gain control over the company.Equity shareholders select the directors who constitute the Board of Directors and Board has the responsibility and power of managing the company. So if another group of shareholders gets more shares then chance of losing control is more.Debt suppliers do not have voting rights but if large amount of debt is given then debt-holders may put certain terms and conditions on the company such as restriction on payment of dividend, undertake more loans, investment in long term funds etc. So company must keep in mind type of debt securities to be issued. If existing shareholders want complete control then they should prefer debt, loans of small amount, etc. If they don’t mind sharing the control then they may go for equity shares also.

Companies often use debt when constructing their capital structure because it has certain advantages compared to equity financing. In general, using debt helps keep profits within a company and helps secure tax savings. There are ongoing financial liabilities to be managed, however, which may impact your cash flow.

2. A company's capital structure — essentially, its blend of equity and debt financing — is a significant factor in valuing the business. The relative levels of equity and debt affect risk and cash flow and, therefore, the amount an investor would be willing to pay for the company or for an interest in it. The capital structure has positive relationship with the firm value. In addition, an increase in firm quality, tangibility, firm growth and GDP growth rate can improve the firm value.