Companies can choose any combination of debt and equity they wish to finance their assets, subject to the willingness of investors to provide such funds. And, as we’ll see, there are many different combinations of debt and equity, or capital structures: At some companies, like the Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other companies, like Microsoft, have little or no financing. debt.
In the following sections, we discuss the factors that affect a company’s capital structure and conclude that a company should attempt to determine what its best or optimal mix of financing should be. But you’ll find that determining the exact optimal capital structure isn’t rocket science, so after looking at a number of factors, a company sets a target capital structure that it believes to be optimal, which is then used as a guide for raising funds in the future. . This objective may change over time as conditions vary, but at any given time the company’s management has a specific capital structure in mind and individual financial decisions must be consistent with this objective. If the actual debt ratio is below the target level, new funds are likely to be raised through debt issuance, while if the debt ratio is above the target, shares will likely be sold to get the company back on track. in line with target debt/target. asset ratio.
The capital structure policy implies a compromise between risk and return. Using more debt increases the risk to the company’s profit stream, but a higher proportion of debt generally leads to a higher expected rate of return; And we know that the increased risk associated with higher debt tends to drive down stock prices. At the same time, however, the higher expected rate of return makes the stock more attractive to investors, which, in turn, ultimately drives up the stock price. Therefore, the optimal capital structure is one that strikes a balance between risk and return to achieve our ultimate goal of maximizing share price.
Four main factors influence capital structure decisions:
1. The first is the company’s commercial risk, or the risk that would be inherent in the company’s operations if it did not use debt. The higher the company’s business risk, the lower the optimal amount of debt.
2. The second key factor is the fiscal position of the company. One of the main reasons to use debt is that the interest is tax deductible, which reduces the effective cost of debt. However, if much of a company’s income is already tax-sheltered from accelerated depreciation or accrued tax losses, its tax rate will be low and debt won’t be as advantageous as it would be for a company with a higher effective tax rate. .
3. The third important consideration is financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that a steady supply of capital is needed for stable operations, which, in turn, is vital to long-term success. They also know that when money is tight in the economy, or when a company experiences operational difficulties, a strong balance sheet is needed to obtain funds from capital providers. Therefore, it might be advantageous to issue shares to strengthen the capital base and financial stability of the company.
4. The fourth determining factor of debt has to do with the managerial attitude (conservatism or aggressiveness) with respect to indebtedness. Some managers are more aggressive than others, which is why some companies are more inclined to use debt in an effort to boost profits. This factor does not affect the optimal or value-maximizing capital structure, but it does influence the target capital structure that a company actually establishes.
These four points largely determine the target capital structure, but, as we will see, operating conditions can cause the actual capital structure to vary from the target at any given time. For example, as discussed in the Management Perspective at the beginning of the chapter, Unisys’ debt/asset ratio has clearly been . much higher than its target, and the company has taken some significant corrective steps in recent years to improve its financial position.