Question

There are many reasons that a firm may not operate at its optimal capital structure.  Choose two reasons that prevent a firm from moving to its optimal capital structure and explain each in detail.  

Answer 1

Answer of question = There are many reasons that a firm may not operate at its optimal capital structure.  Choose two reasons that prevent a firm from moving to its optimal capital structure and explain each in detail , are as follows :

meaning of capital structure

• The capital structure is the particular combination of debt and equity used by a company to finance its overall operations and growth.
• Debt comes in the form of bond issues or loans,
• while equity may come in the form of common stock, preferred stock, or retained earnings.
• Short-term debt such as working capital requirements is also considered to be part of the capital structure.
• Capital structure can be a mixture of a company's long-term debt, short-term debt, common stock, and preferred stock.
• A company's proportion of short-term debt versus long-term debt is considered when analyzing its capital structure.

meaning of optimal capital structure

• The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital.
• In theory, debt financing offers the lowest cost of capital due to its tax deductibility.
• However, too much debt increases the financial risk to shareholders and the return on equity that they require.
• Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost
• An optimal capital structure is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital.
• Minimizing the weighted average cost of capital (WACC) is one way to optimize for the lowest cost mix of financing.
• According to some economists, in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, in an efficient market, the value of a firm is unaffected by its capital structure.

• Understanding Optimal Capital Structure as follows ,

  The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

Factors which affects the choice of capital structure- are as follows

(1) Cash Flow Position:

• While making a choice of the capital structure the future cash flow position should be kept in mind.
• Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.

2) Interest Coverage Ratio-ICR:

• With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest.
• The capacity of the company to use debt capital will be in direct proportion to this ratio.

(3) Debt Service Coverage Ratio-DSCR:

• This ratio removes the weakness of ICR. This shows the cash flow position of the company.
• This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available.
• Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.

(4) Return on Investment-ROI:

• The greater return on investment of a company increases its capacity to utilise more debt capital.

(5) Cost of Debt:

• The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa.

(6) Tax Rate:

• The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases.
• The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.
• For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).

7) Cost of Equity Capital:

• Cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital.
• If the debt capital is utilised more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.
• Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly.
• It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it.

(8) Floatation Costs:

• Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.).
• These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital.
• This attracts the company towards debt capital.

(9) Risk Consideration: There are two types of risks in business:

(i) Operating Risk or Business Risk:

• This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc),

(ii) Financial Risk:

• This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company.
• The total risk of business depends on both these types of risks. If the operating risk in business is less, the financial risk can be faced which means that more debt capital can be utilised. On the contrary, if the operating risk is high, the financial risk likely occurring after the greater use of debt capital should be avoided.

(10) Flexibility:

• According to this principle, capital structure should be fairly flexible. Flexibility means that, if need be, amount of capital in the business could be increased or decreased easily.
• Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.
• If at any given time company has more capital than as necessary then both the above-mentioned capitals can be repaid.
• On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility to issue debt capital and preference share capital is the best.

reasons that prevent a firm from moving to its optimal capital structure, are below :

While designing an optimum capital structure the following factors are to be con­sidered carefully:

1. Profitability:

• An optimum capital structure must provide sufficient profit. So the profitability aspect is to be verified.
• Hence an EBIT-EPS analysis may be performed which will help the firm know the EPS under various financial alternatives at different levels of EBIT.
• Apart from EBIT-EPS analysis the company may calculate the coverage ratio to know its ability to pay interest.

2. Liquidity:

• Along with profitability the optimum capital structure must allow a firm to pay the fixed financial charges.
• Hence the liquidly aspect of the capital structure is also to be tested. This can be done through cash flow analysis.
• This will reduce the risk of insolvency. The firm will separately know its operating cash flow, non-operating cash flow as well as financial cash flow.
• In addition to the cash flow analysis various liquidity ratios may be tested to judge the liquidity position of the capital structure.

3. Control:

• Another important aspect in designing optimum capital structure is to ensure control.
• The supplies of debt have no role to play in managing the firm; but equity holders have right to select management of the firm.
• So more debt means less amount of control by the supplier of funds. Hence the management will decide the extent of control to be retained by themselves while designing optimum capital structure.

4.Industry Average

• The firm should be compared with the other firms in the industry in terms of profitability and leverage ratios.
• The amount of financial risk borne by other companies must be con­sidered while designing the capital structure. Industry average provides a benchmark in this respect.
• However it is not necessary that the firm should follow the industry average and keep its leverage ratio at par with other companies; however, the comparison will help the firm to act as a check valve in taking risk.

5. Nature of Industry:

• The management must take into consideration the nature of the industry the firm belongs to while designing the optimum capital structure.
• If the firm belongs to an industry where sales fluctuate frequently then the operating leverage must be conservative.
• In case of firms belonging to an industry manufacturing durable goods, the financial leverage should be conservative and the firm can depend less on debt.
• On the other hand, firms producing less expensive products and having lesser fluctuation in demand may take an aggressive debt policy.

6. Maneuverability in Funds:

• There should be wide flexibility in sourcing the funds so that firm can adjust its long-term sources of funds if necessary.
• This will help firm to combat any unforeseen situations that may arise in the economic environment. Moreover, flexibility allows firms to avail the best opportunity that may arise in future.
• Management must keep provision not only for obtaining funds but also for refunding them.

7. Timing of Raising Funds:

• Timing is yet another important factor that needs to be considered while raising funds. Right timing may allow the firm to obtain funds at least cost.
• Here the management needs to keep a constant vigil on the stock market, the government’s steps towards monetary and fiscal policies, market sentiment and other macro economic variables.
• If it is found that borrowed funds became cheap the firm may move to issue debt securities.
• It should be noted here that the firm must operate under its debt capacity while designing its capital structure.

8. Firm’s Characteristics:

• The size of the firm and creditworthiness are important factors to be consid­ered while designing its capital structure.
• For a small company the management cannot depend much on the debt because its creditworthiness is limited—they will have to depend on equity.
• For a large concern, however, the benefit of capital gearing may be availed. Small firms have limited access to various sources of funds.
• Even investors are reluctant to invest in small firms. So the size and credit standing also determine capital structure of the firm.

Hope you understand the reasons that prevent a firm to move to its optimal capital structure.

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