CFA Level 1
Corporate Finance - Factors that Influence a Company's Capital-Structure Decision
The primary factors that influence a company's capital-structure decision are:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A utility company generally has more stability in earnings. The company has les risk in its business given its stable revenue stream. However, a retail apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with the company's ability to meet its responsibilities with the capital structure in both good times and bad.
2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.
The airline industry is a good example. In good times, the industry generates significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.