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.