Question

EXPLANATION:
Hello Tutor: please read below point 1 and 2. Those are 2 different answers from 2 different people to the following question: What is the main determinant of capital structure? Explain using example from your readings or from current events’? CAN YOU READ THE BELOW 1 AND 2 ANSWERS AND MAKE ANY COMMENTS, IF YOU AGREE OR NOT AND WHY. Why you agree or disagree, an make any other contribution to the topic. The idea is to have a conversation regarding the "determinants" of capital structure.

Thanks!!

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1) The first determinant in capital structure decision is the pecking order theory. Based on this theory, in case of financial need, the first resource is internal financial funds; if the internal resources are not enough the first source for external need is debt and the second one is equity.

Asymmetric information is another determinant, the example of the text book (page 638) which is about the insider information over the price and value of the firm’s stock shows how this asymmetric information helps the managers to decide on capital structure strategy.

The duration of the leverage such as short term leverage and long term leverage is another factor to determine capital structure.

Profitability and liquidity of the firm have negative relation with leverage, when the firm is profitable and has proper liquidity, in case of financial need, it can use internal resources so the leverage decreases. In the other side growth and size of the company have positive relation with leverage; high-growth firms and large-sized firms are heavily depended on external financial resources specially on debt. Finally, tangibility which has positive relation with debt ratio is another determinant factor in capital structure because the firm can collateralize the tangible asset to increase the debt.

2)

Capital structure relates to how firms choose to finance its assets and investments. The mix of debt and equity for a firm is its optimal capital structure. It is one that maximized the value of firms and minimizes the overall cost of capital (Ross, pg., 644)   Capital structure is really a reflection of its borrowing policy. There are many traits that contribute to the changes in firm’s debt to equity preferences or the determinant of the capital structure (Ross, pg. 609). If a firm borrow too much debt, the firm become high risk of going bankrupt. What also affects firm’s capital structure is restructuring with no direct effect on the firm’s assets, therefore the immediately effect increase debt and decrease equity (Ross, pg. 608).
Capital structure will take into account other factors such as growth, size Uniqueness and profitability.
Growth: Firms usually prefer equity financing over other investment prospects. This is so because Equity financing tends to increase per share price and assets of firms and also measures the growth of total assets as a percentage of change in total assets.
Uniqueness: Firms of recent are looking to be unique through research and development to be different form other firms in the industry.
Size: Small firms pays more for issuing debt or equity compared to large firms.
Profitability: Firms prefer to raise capital first from, retained earnings, then debt and then equity either because of the behavior of the firm’s past profitability, and also the earnings that management would like to retain in the company. ((Titman & Wessels, 1988)

Answer 1

Both point 1 and point 2 have some theoretically valid arguments. But, practically or in the real business world, the things could be different.

Both point 1 and 2 rightly point out that firms may want to use internal resources first and then go with external resources such as debt or equity. This is because generally procuring funds from outside will have higher costs in terms of dividend expectations ( for equity) or interest (for debt).

The firm may choose external funding for various reasons - the most common being inadequate internal funds, Once, funds are sought from outside the choice between equity and debt may arise. Apart from points mentioned in point 1 and point 2 of your question, a few other things that could determine choice between equity and debt are:

1) Availability - which one is more readily available, say is it easier to get a bank loan than raise it from shareholders.

2) Tax - some tax laws (domestic and international) could make it either equity or debt tax friendly. For example, in some economies, interest paid may be shown as an expense reducing profits and thus reducing tax burden, But, dividends paid may not be shown as an expense as they may be assumed to be paid out of taxable profits.

In short, there is no hard and fast rule to determine which capital structure is ideal. It is with keeping various principles discussed above in mind that the CFO or a top executive of a firm will apply his best judgement to come up with a capital structure.