Batch – A
Factors Determining Optimal Capital Structure
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-
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-