Question

Question 2:
To what extent should a firm use debt? Consider both theoretical and practical factors that
might influence a firm’s choice of capital structure.

Answer 1

The examination of the amount of debt should be done with respect to debt-to-equity or debt-to-capital. The extent of debt to be used is subjective to various factors:

Industry sector - The sector in which the firm operates influences the amount of debt. Sectors that are less capital intensive and higher-cashflows may find it easier to get debt at a cheaper cost. Since equity is perceived to be expensive than debt, if the cost of debt is low, the firm can reduce its cost of capital. Also, sectors that are capital intensive and faces earnings volatility may find it difficult to arrange debt and may get debt at a higher cost.

Management outlook and strategy - This is a firm-specific factor and related to the type of management the firm has. If a firm has aggressive management, it may consider taking on higher debt, since raising capital through equity is perceived to be expensive. On the other hand if the management is cautious and is highly risk-averse, they may consider lower debt or lower leverage.

Firm's financials - A firm's financial position and cash-flows generating capacity play an important role in determining the amount of debt. If a firm has higher operating cash-flows, and have low earnings and revenue volatility, the firm can easily service its debt. Moreover, the firm can keep its Debt to service ratio under acceptable levels and vice-versa.

Market outlook - Market outlook related to the interest rate regime and the overall market sentiment. If the firm needs immediate capital for expansion, and the market sentiment is very poor, a firm may not be able to raise enough equity. In such a case, a firm may consider raising capital through debt to meet its requirement. Also, if the market interest rates are low, debt may appear cheaper for a firm and the firm may be taken on additional debt to gain an advantage of the low-interest rate regime. As against, if the market interest rates are too high, a firm may abstain from taking higher debt due to the higher cost associated.