The Target Capital Structure

Firms should first analyze a number of factors, then establish a target capital structure. This target may change over time as conditions change, but at any given moment, management should have a specific capital structure in mind. If the actual debt ratio is below the target level, expansion capital will probably be raised by issuing debt, whereas if the debt ratio is above the target equity will probably be used.

• Using more debt raises the risk borne by stockholders.
• However, using more debt generally leads to a higher expected rate of return.

Higher risk tends to lower a stock’s price, but a higher expected rate of return raises it. Therefore the optimal capital structure must strike that balance between risk and return which maximizes the firm’s stock price.

Four primary factors influence capital structure decisions.

1. Business risk or the riskiness inherent in the firm’s operations if it used no debt. The greater the firm’s business risk. the lower its optimal debt ratio.

2. The firm’s tax position. A major reason for using debt is that interest is deductible, which lowers the effective cost of debt. However, if most of a firm’s income is already  sheltered from taxes by depreciation tax shields, interest on currently out standing debt, or tax loss carry-forwards its tax rate will be low. so additional debt will not be as advantageous as it would be to a firm with a higher effective tax rate.

3. Financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a steady supply of capital is necessary for stable operations, which is vital for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, suppliers of capital prefer to provide funds to companies with strong balance sheets. Therefore, both the potential future need for funds and the consequences of a funds shortage influence the target capital structure-the greater the probable future need for capital and the worse the consequences of a capital shortage, the stronger the balance sheet should be.

4. Managerial conservatism or aggressiveness. Some managers are more aggressive than others,  hence some firm’s are more inclined to use debt in a effort to boost profits. This factor does not affect the true optimal, or value maximizing. Capital structure, but it does influence the manager-determined target capital structure.

These four points largely determine the target capital structure, but operating conditions can cause the actual capital structure to vary from the target. For example, Illinois power has a target debt ratio of about 45 percent, but large losses associated with a nuclear plant forced it to write down its common equity, and that raised the debt ratio above the target level. The company is now trying to get its equity back up to the target level.