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Factors Determining Optimal Capital Structure

Factors Determining Optimal Capital Structure

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Published by Arindam Mitra

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Categories:Types, Research
Published by: Arindam Mitra on Feb 28, 2011
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Financial ManagementAssignment on Factors DeterminingOptimal Capital Structure
ITM Business School, Kharghar 
Submitted To:                                    SubmittedBy:Prof. Bharat ShahArindam MitraKHR2009PGDMF002
 
Batch – A
Factors Determining Optimal Capital Structure
Introduction
The capital structure of a company has to be planned initially when it ispromoted. The initial capital structure should be designed very carefully. Themanagement of the company should set a target capital structure and thesubsequent financing decisions should be made with a view to achieve thetarget capital structure. The financial manager has also to deal with anexisting capital structure. The company needs funds to finance its activitiescontinuously. Every time when the funds have to be procured, the financialmanager weighs pros and cons of various sources of finance and selects themost advantageous sources keeping in view the target capital structure.Thus the capital structure decision is a continuous one and has to be takenwhenever a firm needs additional finances.Generally the following factors should be considered whenever a capitalstructure decision has to be taken-
1. Assets
The forms of assets held by a company are important determinants of its capital structure. Tangible fixed assets serve as collateral to debt.In the event of financial distress, the lenders can access these assetsand liquidate them to realize funds lent by them. Companies withhigher tangible fixed assets will have less expected costs of financialdistress and hence, higher debt ratios. On the other hand, companies,whose primary assets are intangible assets will not have much to offerby way of collateral and will have higher costs of financial distress.
2. Growth opportunities
The nature of growth opportunities has an important influence on afirm’s financial leverage. Firms with high market to book value ratioshave high growth opportunities. A substantial part of the value forthese companies comes from organizational or intangible assets.These firms have a lot of investment opportunities. There is also higherthreat of bankruptcy and high costs of financial distress associatedwith high growth firms once they start facing financial problems. Thesefirms  employ  lower  debt  ratios  to  avoid  the problem  of  under-
 
investment and costs of financial distress. High growth firms wouldprefer to take debts with lower maturities to keep interest rates downand to retain the financial flexibility since their performance canchange unexpectedly any time. They would also prefer unsecured debtto have operating flexibility. Mature firms with low market to bookvalue ratio and limited growth opportunities face the risk of managersspending free cash flow either in unprofitable maturing business ordiversifying  into  risky  businesses.  Both  these  decisions  areundesirable. This behavior of managers can be controlled by highleverage that makes them more careful in utilizing surplus cash.
3. Trading on equity
The use of fixed cost sources of finance, such as debt and preferenceshare capital to finance the assets of the company is known asfinancial leverage or trading on equity. The word “equity” denotes theownership of the company. If the assets financed with the use of debtyield a return greater than the cost of debt, the earnings per shareincrease without an increase in the owner’s investment. The earningsper share also increase when the preference share capital is used toacquire assets. But the leverage impact is more pronounced in case of debt because (a) the cost of debt is usually lower than the cost of preference  share  capital  and  (b)  the  interest  paid  on  debt  taxdeductible. Because of its effect on earnings per share, financialleverage is one of the important considerations in planning the capitalstructure of a company. The companies with high level of earningsbefore interest and taxes (EBIT) can make profitable use of the highdegree of leverage to increase return on the shareholder’s equity.The EBIT-EPS analysis is one important tool in the hands of thefinancial manager to get an insight into the firm’s capital structuremanagement. He can consider the possible fluctuations in EBIT andexamine their impact on EPS under different financial plans. If theprobability of earning a rate of return on the firm’s assets less than thecost of debt is insignificant, a large amount of debt can be used by thefirm in its capital structure to increase the earnings per share. Thismay have a favorable effect on the market value per share. On theother hand, if the probability of earning the rate of return on the firm’sassets less than the cost of debt is very high, the firm should refrainfrom employing debt capital. It may thus be concluded that the greaterthe level of EBIT and lower the profitability of downward fluctuation,the more beneficial it is to employ debt in capital structure.
4. Debt and Non-debt Tax shields

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