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Factors Affecting Capital Structure Decision Of A Firm

Capital structure of a firm is determined by various internal and external factors. Following are the main factors which affect the capital structure decision.

1. Size Of A Firm
There is a positive relation between the capital structure and size of a firm. The large firms are more diversified, have easy access to the capital market, receive higher credit ratings for debt issues, and pay lower interest rate on debt capital. Further, larger firms are less prone to bankruptcy and this implies the less probability of bankruptcy and lower bankruptcy costs. Therefore, larger firms tend to use more debt capital than smaller firms.

2. Growth In Sales
Anticipated growth rate in sales provides a measure of extent to which earning per share (EPS) of a firm are likely to be magnified by leverage. The firm is likely to use debt financing with limited fixed charge only when the return on equity is likely to be magnified. However, the firms with significant growth in sales would have high market price per share as a result of which they might prefer equity financing. The firm should make a relative cost benefit analysis against debt and equity financing in anticipation to growth in sales to determine appropriate capital structure.

3. Business Risk
There is negative relation between the capital structure and business risk. The chance of business failure is greater if the firm has less stable earnings. Similarly, as the probability of bankruptcy increases the agency problems related to debt become more aggravating. Thus, as business risk increases, the debt level in capital structure of the enterprises should decrease.

4. Debt Service Capacity
The higher debt level in capital structure increases the probability of bankruptcy and bankruptcy costs of the enterprises. Probability of  bankruptcy refers to the chances of cash flows to be less than the amount required for servicing the debt. The debt service ratio measured by the ratio of operating income to total interest charges indicates the firm's ability to meet its interest payment out of its annual operating earnings. Therefore, the higher debt service ratio shows the higher debt capacity of the enterprises. Hence, there is the positive relation between the debt service capacity and capital structure of the firm.

5. Operating Leverage
The use of fixed cost in production process also affects the capital structure. The high operating leverage; use of higher proportion of fixed cost in the total cost over a period of time; can magnify the variability in future earnings. There is negative relation between operating leverage and debt level in capital structure. Higher the operating leverage, the greater the chance of business failure and the greater will be the weight of bankruptcy costs on enterprise financing decisions.

6.Stability In Cash Flow
The firm's cash flow stability also affects its capital structure. If firm's cash flows are relatively stable, then it may find no difficulties in meeting its fixed charge obligation. As a result, the firm may attempt to take the benefits by using leverage to some extent.

7. Nature Of Industry
Capital structure of a firm also depends on the nature of industry in which it operates. If there were no barriers in industry for the entry of new competing firms, the profit margin of existing firms in the industry would be adversely affected. As a result, the firm may find a more risky to use fixed charge bearing securities.

8. Asset Structure
The sources of financing to be used are affected to several ways by the maturity structure of assets to be used by the firm. If a firm has relatively longer term assets with assured demand of their products, the firm attempts to use more long term debt. In contrast to this, the firms with relatively greater investment in receivables and inventory rather than fixed assets rely heavily on short-term financing.

9. Lender's Attitude
Lender of any firm permits the use of debt financing only to a limited range. If management seeks to use leverage beyond that permitted by industry norms, this may reduce the credit standing and credit rating of the firm. As a result, lenders do not permit for additional debt financing.

2 comments:

John Hankinson said...

Very nice post about factors affecting capital structure decision of a firm. This article will be helpful to those who want to gain information about capital accounts. I will share this information to all my friends, thanks for sharing!

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Hima Bindu Karuturi said...

I have seen this blog when i am searching for CCA method. Great work. I dont know whether i can clear my doubt here. But, I want to know about "challenges of financial management team when a new business is integrated into existing financial structure- in terms of Capital planning,financial budget, chart of accounts, key performance indicators, financial & management routine.Could you please help me regarding this.

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