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Critical factors in determining the Capital Structure
Apart from Earning Per Share (EPS), value, and cash flow, there are additional factors that need to be considered while determining the capital structure of a company. Some of the most common factors are as follows −
Assets
If a company has more tangible assets, its chances of financial distress automatically goes down. Lenders can use the tangible assets to realize their funds by liquidating the assets in the case the company goes bankrupt. Hence, companies that do not have many tangible assets have debt at a costlier rate.
Growth Opportunities
The companies with higher market-to-book value have a larger share of intangible assets in their capital structure. Therefore, they are often subjected to higher market risks than low-growth companies. The chances of high-growth companies going bankrupt are also high, so they have to source debt at a costlier rate than companies whose growth is normal.
Debt and Non-debt Tax Shields
Both debt and non-debt tax shields have a profound effect on the capital structure of a company. While debt offers an interest tax shield from tax-deductible income, reduced taxes are also levied on depreciation, carried forward losses, etc. Tax shields for high-debt companies go higher because these companies have more tangible assets than non-debt tax shield companies.
Financial Flexibility and Operating Strategy
A company must be flexible enough to serve the interest levied on the sourced debts it accumulates. High flexibility is required to face all future adversities that may be seen or unseen while operating a business. That is why the operating strategy of a company must be in sync with the debts sourced from the lenders or from the market.
Loan Covenants
Loan covenant may restrict companies from using various strategies to cover debts and could be detrimental for the company in the long run. For example, covenants can make it impossible to raise more debt from themarket after a certain limit making the companies restricted in a financialtrap. Therefore, these options should be considered seriously before opting for debts that come with such loan covenants.
Financial Slack
The financial flexibility of a company is dependent upon its financial slack which consists of the serviceable and non-serviceable debt capacity of the firm. The usable or serviceable debt capacity is important because it shows the limits of debt a company can have in its capital structure. The more a company's debt capacity, the higher will be its flexibility.
Sustainability and Feasibility
The capital structure model should be sustainable and feasible for the run if a company has to grow and profit from its capital structure model. For analyzing the growth and profitability, the sustainable growth model is used. The model assumes that companies rely on internal financing and debt for sourcing their funds and does not issue shares during the planning horizon. It depends mainly on the retention ratio and returns on equity.
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