The capital structure determinants in practice may involve considerations in addition to the concerns about earning per share, value of the company and cash and funds flow.
structure determinants in practice
The capital structure
determinants in practice may involve considerations in addition to the concerns
about earning per share, value of the company and cash and funds flow.
A company may have enough debt
servicing ability but it may not have assets to offer as collateral. Management
of companies may not willing to lose their grip over the control and hence they
not be taking up debt capital even if they are in their best interest.
the very important considerations are briefly covered below:
Companies with growth
opportunities may probably find debt financing very expensive in terms of
interest to be paid and this may arise due to non availability of adequate
unencumbered collateral securities. This may result in losing the investment
High growth companies may prefer
to take debts with lower maturities to keep interest rates down and to retain
the financial flexibility since their performance can change unexpectedly at
any point of time. They would also prefer unsecured debt to have flexibility.
Strong and mature companies have
tangible assets and stable profits. Thus they may have low costs of financial
distress. These companies would therefore raise debts with longer maturities as
the interest rates will not be high for them and they have a lesser need of
financial flexibility since their performance is not expected to be altered
suddenly. They would also be availing the interest tax shields which in turn
will enhance the value of the companies.
The assets and the form of assets
held by the companies are very important determinants of their capital
Tangible unencumbered fixed
assets serve as a collateral security to debt. In the event of any unforeseen
financial distress, the creditors can have recourse to these assets and they
may be able to recover their debt by foreclosing such assets.
Companies with large tangible
assets will have very less financial distress and costs and they will be
preferred by the creditors.
Companies with intangible assets will not have any
Non debt and debt tax
The tax provisions provide for
deduction of interest paid on debt and therefore the debt capital can increase
the company’s after tax free cash flows. Therefore this interest shield
increases the value of the company.
This tax advantage of debt
implies that companies will employ more debt to reduce tax liabilities and
increase value. In practice this is not always true as is evidenced from many
Companies also have non debt tax
shields like depreciation, carry forward losses, etc. This implies that
companies that have larger non debt tax shields would employ low debt as they
may not have sufficient taxable profit to have the benefit of interest
However, there is a link between
non debt tax shields and the debt tax shields because companies with higher
depreciation would tend to have higher fixed assets, which serve as collateral
Companies will normally have a
low level of threat or insolvency perception even though their cash and funds
flows are comfortable. Despite this, the companies may exercise conservative
approach in their financial leverages since the future is very much uncertain
and it may be difficult to consider all possible scenarios of adversity. It is
therefore prudent for the companies to maintain financial flexibility as this
will enable the companies to adjust to any change in the future events.
The creditors providing the debt
capital would insist for restrictive covenants in the long term loan agreements
to protect their interest. Such covenants may include distribution of dividends,
new additional external finances (other than equity issue) for existing or new
projects, maintain working capital requirements at a particular level. These
covenants may therefore restrict the companies’ investment, financing and
dividend policies. Violation of these covenants can lead to serious adverse
consequences. To overcome these restrictive covenants, the companies may ask
for and provide for early repayment provisions even with prepayment penalty
provisions in the loan agreements.
In designing a suitable capital
structure, the management of the companies may decide and desire to continue
control over the companies and this is true particularly in the case of first
generation entrepreneurs. The existing management team not only wants control
and ownership but also to manage the company without any outside interference.
Widely held and closely held companies may opt to pursue appropriate strategies
to hold back their existing management controls.
Issue or floatation costs are
incurred when a company decides to raise debt capital in the market. These debt
issue costs are normally expected to be lower than equity issue costs. This
alone will encourage the companies to pursue debt capital. Retained earnings do
not involve issue costs. The source of debt also influences the issue costs.
Regulations like stamp duty on commercial paper or certificate of deposits may
also jack up the issue cost for the companies.
Thus companies will prefer to go after debt capital
for the following reasons
1. Tax deductibility of interest (availability of tax shield)
2. Higher return to shareholders due to gearing
3. Complicated, time consuming procedure for raising equity capital ӹӹ No dilution of ownership and control
4. Equity results in permanent
commitment than debt
Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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