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Financial Management - CAPITAL STRUCTURE THEORIES

Capital structure frame work

   Posted On :  20.06.2018 03:29 am

A financial capital structure frame work can be structured and evaluated from various perspectives.

Capital structure frame work
 
A financial capital structure frame work can be structured and evaluated from various perspectives.
 
From the company’s point of view, the following may merit consideration
 
1.  Return from investment

2.  Risk associated with the investment
 
3. Value of the investment at different points of time in its life cycle
 
From the investor’s point of view, the following may pose serious questions
 
1.  control of investment
 
2.  flexibility offered by the company
 
3.  feasibility of the investment
 
Therefore by balancing all these considerations, a sound capital structure can be worked out.
 
One such analysis is the FRICT analysis. It is used to help answer a firm’s financing choices. The focus would be on the questions that we are trying to answer and these questions and answers will provide the best choice for the company. The FRICT analysis does not cover other choices such as postponement or cancellation of the project.
 
The four questions that are normally raised in FRICT analysis are
 
1.   How much do we need
 
2.   When will we need it
 
3.   Why – what will it be used for
 
4.   What sources are available
 
The FRICT frame work consists of Flexibility, Risk, Income, Control and Timing

Flexibility

 
First of all, the company should find out its debt capacity and the capital structure determined should be within this debt capacity. And this capacity should not be exceed at any cost and at any time. As we know, the debt capacity depends on the company’s ability to generate future cash flows. Only such cash flows can facilitate prompt repayment – principal and periodic interest payment – to the creditors. This cash flow also should leave some surplus to meet evolving emergent situations. Thus the capital structure should be flexible enough to facilitate it to change its structure with minimum cost and delay due to emerging situations.
 

Risk

 
The variability is in the company’s operations throw open many risks. They may arise due to the macroeconomic factors – industry and company specific – which may be beyond or within the company’s scope. Any large dependence on debt will therefore magnify the possible variance in the company owners’ earnings and at times may threaten the very existence or solvency of the company
 

Income

 
Any debt acquired by the company to build up appropriate capital structure should result in the value addition to the company owners and it should be advantageous by generating maximum returns to the company owners with minimum additional cost (by way of payment of interest and other charges)
 

Control

 
The preferred capital structure should not disturb the management control of the company. Therefore, beyond a certain level, the debt providers may insist for management control and this will be risky for the owners of the company. Hence closely held companies are particularly vulnerable and therefore concerned with the dilution of control
 

Timing

 
The chosen capital structure should provide the following comforts

1.   Feasibility
 
2.   Freedom to implement current and future options
 
Therefore the progression of financing decision is very important in any capital structure framework as any current decision may influence or impact future funding options
 
Therefore our FRICT analysis provides a general framework for managing and evaluating a company’s capital structure. However within this FRICT framework companies can provide comfort to the creditors depending on the particular individual characteristics of the company like affording flexibility, control, etc. This is to provide a general adaptable framework for any company. 
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