Firms can settle whatever mix of debt and equity they desire to finance their assets, subject to the willingness of investors to provide such funds. And, as we shall seek, there exist many different mixes of debt and equity, or capital structures – in some firms, such as Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other firms, such as Microsoft, have tiny or no debt.
In the next few sections, we discuss factors that affect a firm’s capital structure, and we attain a firm should attempt to resolve what its optimal, or best, mix of financing should be. But, you will collect that determining the right optimal capital structure is not a science, so after analyzing a number of factors, a firm establishes a target capital structure it believes is optimal, which is then former as a guide for raising funds in the future. This target might change over time as conditions vary, but at any given moment the firm’s management has a specific capital structure in mind, and individual financing decisions should be consistent with this target. If the steady proportion of debt is below the target level, unique funds will probably be raised by issuing debt, whereas if the proportion of debt is above the target, stock will probably be sold to bring the firm attend in line with the target debt/assets ratio.
Capital structure policy involves a trade-off between risk and return. Using more debt raises the riskiness of the firm’s earnings stream, but a higher propor- tion of debt generally leads to a higher expected rate of return; and, we know that the higher risk associated with greater debt tends to lower the stock’s heed. At the same time, however, the higher expected rate of return makes the stock more fair to investors, which, in turn, ultimately increases the stock’s stamp. Therefore, the optimal capital structure is the one that strikes a balance between risk and return to attain our ultimate goal of maximizing the tag of the stock.
Four valuable factors influence capital structure decisions:
1. The first is the firm’s business risk, or the riskiness that would be inherent in the firm’s operations if it faded no debt. The greater the firm’s business risk, the lower the amount of debt that is optimal.
2. The second key factor is the firm’s tax residence. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However, if great of a firm’s income is already sheltered from taxes by accelerated depreciation or tax loss carryforwards, its tax rate will be crude, and debt will not be as well-behaved as it would be to a firm with a higher effective tax rate.
3. The third famous consideration is financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a proper supply of capital is valuable for stable operations, which, in turn, are critical for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, a strong balance sheet is needed to get funds from suppliers of capital. Thus, it might be suited to announce equity to strengthen the firm’s capital cross and financial stability.
4. The fourth debt-determining factor has to do with managerial attitude (conservatism or aggressiveness) with regard to borrowing. Some managers are more aggressive than others, hence some firms are more inclined to consume debt in an exertion to boost profits. This factor does not affect the optimal, or value- maximizing, capital structure, but it does influence the target capital structure a firm actually establishes.
These four points largely resolve the target capital structure, but, as we shall observe, operating conditions can cause the steady capital structure to vary from the target at any given time. For example, as discussed in the Managerial Perspective at the beginning of the chapter, the debt/assets ratio of Unisys clearly has been . worthy higher than its target, and the company has taken some indispensable correc- tive actions in modern years to improve its financial station.