Question

1. Discuss the various implications for managers when making capital structure decisions.

Answer 1

Capital structure decisions are very important from a manager's point of view. The capital structure of a firm basically refers to the different options used by the firm to finance its assets. The firm can go for different mixes of debt and equity.

- Business Risk - Value of a firm depends on its D/E ratio so managers should critically view the D/E ratio to increase the firm's value or shareholder's value. Debt Financing - Suppose a firm has increased its D/E ratio by taking more debt to finance its business. If the firm fails to pay back this debt within a given time so this can badly impact the credit rating of the firm. Hence managers should carefully analyze the factors that can affect its credit rating and there is a high risk of bankruptcy if it has only debt-financing. Equity Financing - Only Equity-financing could also be very risky for a firm. The optimal level of D/E ratio is required to increase a firm's value. It should be noted that D/E ratio differs between companies, industries, and countries.

- Profitability - The capacity for borrowing for a profitable firm is more. Moreover, Lenders will be more willing to provide loans because the risk of default is lower. Because profitable firms also pay higher taxes, it is reasonable to have more debt to take advantage of debt interest tax shields. So managers should look at the profitability of the firm and also the industrial performance & trend of profitability before making any capital structure decision.

Agency Cost -Debt can be used as a means to reduce the agency cost.

Asset Structure - According to Akhtar and Oliver, companies can take debt at a lower interest rate if they have stable and long-term value assets. This means that companies that have less non-current assets generally have higher costs of debt due to the lack of stable assets. So if a firm has stable and long term value assets then the manager can logically go for debt-financing