Capital Structure Decisions

In addition to the types of analyses discussed above, firms generally consider the following factors when making capital structure decisions:

1.    Sales Stability. A firm whose sales are relatively stable can safely take on more debt and incur higher fixed changes than a company with unstable sales.

2.    Asset structure. Firms whose assets are suitable as security for loans tend to use debt rather heavily. General-purpose assets which can be used by many businesses make good collateral. Whereas special-purpose assets do not. Thus real estate companies are usually highly leveraged, whereas companies involved in technological research are not.

3.    Operating leverage. Other things the same, a firm with less operating leverage is better able to employ financial leverage because it will have less business risk. (This is discussed in greater detail in Appendix 13.A.)

4.    Growth rate. Other things the same, faster-growing firms must rely more heavily on external capital. Further, the flotation costs involved in selling common stock exceed those incurred when selling debt, which encourages them to rely more heavily on debt. At the same time, however rapidly growing firms often face greater uncertainty, which tends to reduce their willingness to use debt.

5.    Profitability. One often, observes that firms with very high rates of return on investment use relatively little debt. Although there is no theoretical justification for this fact, one practical explanation is that very profitable firms such as Intel, Microsoft, and Coca-Cola simply do not need to do much debt financing, Their high rates of return enable them to do most of their financing with internally generated funds.

6.    Taxes. Interest is a deductible expense, and deductions are most valuable to firms with high tax rates. Therefore the higher a firm’s tax rate, the greater the advantage of debt.

7.    Control. The effect of debt versus stock on a management’s control position can influence capital structure. If management currently has voting control (over 50 percent of the stock) but is not in a position to buy any more stock, it may choose debt for new financings. On the other hand management may it may choose debt for new financings. On the other hand, management may decide to use equity if the firm’s financial situation is so weak that the use of debt might subject it to serious risk of default, because if the firm goes into default, the managers will almost surely lose their jobs. However, if too little debt is used, management runs the risk of a takeover. Thus, control considerations could lead to the use of either debt or equity, because the type of capital that best protects management will very from situation to situation. In any event, if management is at all insecure, it will consider the control situation.

8.    Management attitudes. Since no one can prove that one capital structure will lead to higher stock prices than another, management can exercise its own judgment about the proper capital structure. Some managements tend to be more conservative than others and thus use less debt than the average firm in their industry, whereas aggressive managements use more debt in the quest for higher profits.

9.    Lender and rating agency attitudes. Regardless of managers own analyses of the proper leverage factors for their firms, lenders and rating agencies attitudes frequently influence financial structure decisions. In the majority of cases, the corporation discusses its capital structure with lenders and rating agencies and gives much weight to their advice. For example, one large utility was recently told by Moody and Standard & Poor that its bonds would be downgraded if it issued more bonds. This influenced its decision to finance its expansion with common equity.

10.  Market conditions. Conditions in the stock and bond markets undergo both long and short run changes that can have an important bearing on a firm’s optimal capital structure. For example, during a recent credit crunch, the junk bond market dried up and their was simply no market at a reason able interest rate for any new long term bonds rated below triple B. Therefore, low rated companies in need of capital were forced to go to the stock market or to the short term debt market, regardless of their target capital structures. When conditions eased, however these companies sold bonds to get their capital structures back on target.

11.  The firm’s internet condition. A firm’s own internal condition can also have a bearing on its target capital structure. For example, suppose a firm has just successfully completed an R&D program and it forecasts higher earnings in the immediate future. However, the new earnings are not yet anticipated by investors, hence are not reflected in the stock price. This company would not want to issue stock it would prefer to finance with debt until the higher earnings materialize and are reflected in the stock price. Then it could sell an issue of common stock, retire the debt and return to its target capital structure. This point was discussed earlier in connection with asymmetric information and signaling.

12.  Financial flexibility. An astute corporate treasurer made this statement to the authors:

       Our company can earn a lot more money from good capital budgeting and operating decisions than from good financing decisions. Indeed we are not sure exactly how financing decisions affect our stock price, but we know for sure than having to turn down a promising venture because funds are not available will reduce our long run profitability. For this reason my primary goal as treasurer is to always be in a position to raise the capital needed to support operations.

We also know that when times are good we can raise capital with either stocks or bonds but when times are bad, suppliers of capital are much more willing to make funds available if we give them a secured position and this means debt. Further when we sell a new issue of stock this sends a negative signal to investors, so stock sales by a mature company such as ours are not desirable.

Putting all these thoughts together gives rise to the goal of maintaining financial flexibility, which from an operational viewpoint means maintaining adequate reserve borrowing capacity. Determining an adequate reserve borrowing capacity is judgmental bit it clearly depends on the factors discussed including the firm’s forecasted need for funds, predicted capital market conditions management’s confidence in its forecasts and the consequences of a capital shortage.