Question

Pick one of the following to answer: What influence or impact would the position of the firm in its life cycle have on the firm's capital structure choice? What influence would the firm's industry (or segment in a multi-segment firm) have on the firm's (segment's) capital structure choice? What influence would management/ownership structure have on the firm's choice of capital structure? Pick another variable of your liking and describe its influence on the firm’s capital structure choice.

Answer 1

Capital Structure decisions are associated with the means of arranging capital from different sources in order to match the need of long-term funds for the organisation. The descion revovles around the selecting the appropriate source of capital such as equities share capital , preference share capital, long-term loans (liabilities), debentures,bonds, etc. Capital structure decsions are extremely important and play a significant role in financial management of an organisation.

Part 1) Position of a firm in its life cycle will impact the capital structure decision.Firms operating at an early stage will prefer sourcing capital by raising funds from equity. This is because the profits at this stage are low and need to be reinvested in order to grow the business. Such firms may not be able to afford the high interest cost associated with debt capital. On the other hand, firms at a later stage in its life cycle will prefer debt as they may not be willing to dilute their stakeholding by raising equity capital and can afford the interest cost out of profits.

Part 2) Firm's industry also impacts the capital structure decision. The nature of industry and the method of production used in the industry or product type influences the capital structure. Companies in the Trading Industry might rely more on equity or preference capital to meet their capital requirement since they have low asset base to raise debt. On the other hand, monopolistic industries can raise capital through debt as they can pay off the interest cost through high profits without dilution of stake. Industries with no barrier , rely more on equity capital since they have higher risks associated with business that they might become unable to pay off fixed costs in future.

Part 3) Negative or an inverse relationship exists between the managerial own shareholding and leverage ratio (Debt in capital structure ) .This means that in the presence of managerial shareholding , the leverage ratio will be low because leverage means high risk for business and managers of the company.When part of ownership is less with management, the company might opt for risky financing like debt which incurs a fixed cost.

Part 4) Tax Structure. Interest payments on debt are tax deductible whereas dividend payments on equity are not. This means that if a firm is expecting to have high profits in a country with high tax regime, then the tax liability will be higher. In such a scenario, the firm might opt for more debt in the capital structure to reduce the tax liability with interest payments. Hence, Tax Structure impacts the capital structure decisions and plays a key role in financial management.