Factors affecting Capital Structure of a firm
Capital structure is the mix of the long-term sources of funds used by a firm. It is made up of debt and equity securities and refers to the permanent financing of a firm. Capital structure is how a firm finances its overall operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Every company needs capital to support its operations. Capital structure is a blend of the company’s sources of finance and consists of several types of funding.
Some of the key factors that affect the capital structure of the firm are as follows:
a) Business Risk:
There is a negative relationship between capital structure and business risk. The chance of business failure is greater if the firm has less stable earnings. Similarly, as the probability of bankruptcy increases, the agency problems related to debt become more aggravating.
Thus, as business risk increases, the debt level in the capital structure of the enterprises should decrease.
- Higher business risk may lead to a lower debt-to-equity ratio as lenders may be hesitant to provide funds to a risky business.
- Lower business risk may encourage firms to take on more debt as they can confidently meet their financial obligations.
b) Growth In Sales:
The anticipated growth rate in sales provides a measure of the extent to which earning per share (EPS) of a firm are likely to be magnified by leverage. The firm is likely to use debt financing with a limited fixed charge only when the return on equity is likely to be magnified.
However, the firms with significant growth in sales would have a high market price per share as a result of which they might prefer equity financing. The firm should make a relative cost-benefit analysis against debt and equity financing in anticipation to growth in sales to determine the appropriate capital structure.
- Rapid sales growth may require more capital for expansion, leading to increased debt or equity issuance.
- Slower sales growth may result in a conservative capital structure with less debt to avoid financial strain.
c) Operating Leverage:
The use of fixed cost in the production process also affects the capital structure. The high operating leverage; use of a higher proportion of fixed cost in the total cost over a period of time; can magnify the variability in future earnings. There is a negative relation between operating leverage and debt level in the capital structure.
Higher the operating leverage, the greater the chance of business failure and the greater will be the weight of bankruptcy costs on enterprise financing decisions.
- High operating leverage, where fixed costs are a significant portion of total costs, may lead to a lower debt-to-equity ratio to reduce financial risk.
- Low operating leverage allows firms to use more debt to leverage their operations.
d) Stability In Cash Flow:
The firm’s cash flow stability also affects its capital structure. If a firm’s cash flows are relatively stable, then it may find no difficulties in meeting its fixed charge obligation. As a result, the firm may attempt to take benefits by using leverage to some extent.
- Stable and predictable cash flows can support higher debt levels, as firms are better equipped to make interest and principal payments.
- Unstable cash flows may necessitate a more equity-heavy capital structure to avoid financial distress.
e) Nature Of Industry:
The capital structure of a firm also depends on the nature of the industry in which it operates. If there were no barriers in the industry for the entry of new competing firms, the profit margin of existing firms in the industry would be adversely affected. As a result, the firm may find a riskier to use fixed charge bearing securities.
- Capital-intensive industries (e.g., manufacturing) may require higher debt levels due to substantial investment needs.
- Less capital-intensive industries (e.g., technology) may use more equity financing due to lower asset requirements.
f) Asset Structure:
The sources of financing to be used are affected in several ways by the maturity structure of assets to be used by the firm. If a firm has relatively longer-term assets with assured demand of its products, the firm attempts to use more long-term debt.
In contrast to this, firms with relatively greater investments in receivables and inventory rather than fixed assets rely heavily on short-term financing.
- Firms with easily collateralizable assets may find it easier to secure debt financing and may have higher debt ratios.
- Firms with intangible or non-collateralizable assets may rely more on equity financing.
g) Lender’s Attitude:
The lender of any firm permits the use of debt financing only to a limited range. If management seeks to use leverage beyond that permitted by industry norms, this may reduce the credit standing and credit rating of the firm. As a result, lenders do not permit additional debt financing.
- Lenders’ willingness to provide debt financing and their terms can impact a firm’s capital structure. Favorable terms may encourage more debt issuance.
- Stringent lending conditions may push firms towards equity financing.
h) Management Style:
Management styles range from aggressive to conservative. The more conservative a management’s approach is, the less inclined it is to use debt to increase profits. Aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company’s earnings per share (EPS).
- Conservative management may prefer a lower debt burden to minimize financial risk.
- Aggressive management may opt for higher leverage to maximize returns but at the cost of increased financial risk.
i) Company’s Tax Exposure:
Debt payments are tax-deductible. As such, if a company’s tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
- Firms in high-tax jurisdictions may use debt financing to take advantage of tax deductions on interest payments.
- Low-tax exposure firms may rely more on equity financing as interest deductions provide fewer tax benefits.
j) Market Conditions:
Market conditions can have a significant impact on a company’s capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies’ access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay.
In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
- Favorable market conditions (low interest rates, high investor demand) may encourage firms to use more debt.
- Unfavorable conditions (high interest rates, market instability) may lead to a more equity-focused capital structure.
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MBA,BBA.
I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,