What are the primary factors that should be considered when establishing a firm’s capital structure?

Published by Jeannie R. Ferrell

Dec 8, 2022

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A firm’s capital structure is determined by more than just a component cost for each source of capital and is not fixed over time. Rather, the capital structure of a firm is determined by conditions in the domestic and international economies, and it should also reflect changing conditions in the economy. In other words, the relationship between risk and return should be the major consideration in establishing the capital structure of the firm and the value of the firm.
Address one of the following prompts in a brief but thorough manner.
What is the relationship between risk and return and how is this reflected in the value of the firm’s stock? The cost of debt?
What are the primary factors that should be considered when establishing a firm’s capital structure?
Your posting should be approximately 500 words in length.
The following below are two discussion posts that need responses. Please respond separately.
1.
What are the primary factors that should be considered when establishing a firm’s capital structure?
Introduction:
The capital structure of a firm is one of the most important decisions that a manager needs to make in order to maximize value for their shareholders. It is essential to consider various factors when determining the appropriate capital structure or optimal debt-to-equity ratio, as this will directly impact the firm’s ability to raise new funds and finance projects (“capital asset pricing model,” 2011).
Tax Shield:
One factor that needs to be considered when assessing a company’s optimal capital structure is its ability to benefit from tax shields associated with taking on additional debt. Interest payments on debt are usually tax deductible, meaning they can reduce the company’s taxable income, which in turn reduces its overall tax burden. This can provide companies with an additional source of financing for projects and investments. For example, Apple Inc has used this strategy to reduce its effective tax rate from 24.2% in fiscal year 2018 to 15.8% in fiscal 2019 by taking on debt and using the interest payments as a tax shield.
Market Conditions:
The current condition of the markets should also be taken into consideration when determining a companys capital structure. If the market is doing well and stock prices are rising, then equity may be a better choice than debt as it would allow the company to benefit from higher share prices without having to pay any interest or principal payments on their debt. On the other hand, if the markets are bearish and stock prices are falling, then debt may be a better option as it would provide the company with some much needed liquidity while also allowing them to benefit from a lower cost of capital.
Financial Leverage:
The financial leverage of a company should also be taken into consideration when assessing its optimal capital structure. Financial leverage is calculated by dividing total liabilities by total assets and is used to measure how much debt a company has relative to its equity. A higher level of financial leverage indicates that the company is more heavily reliant on debt as opposed to equity for financing projects (“capital asset pricing model,” 2011). Companies that have high levels of financial leverage can potentially increase their risk profile and may need to adjust their capital structure in order to reduce their leverage ratio.
Debt Capacity:
The debt capacity of a company should also be taken into consideration when assessing its optimal capital structure. Debt capacity measures the amount of additional debt that a company can take on without damaging its credit rating or financial position (Panteghini et al., 2021). Companies with high levels of debt may not have enough capacity to take on new debt, which could restrict their ability to finance projects and investments. On the other hand, companies with low levels of existing debt may have more capacity to take on additional debt in order to fund new projects.
Business Risk:
The business risk profile of a company is another important factor that needs to be taken into consideration when determining its optimal capital structure (Panteghini et al., 2021). Business risk is the level of uncertainty associated with a company’s operations and ability to generate cash flows. Companies that operate in highly competitive industries or markets may need to adjust their capital structure in order to reduce their business risk profile. This could include using more equity financing rather than debt, as this would help reduce the amount of leverage and provide investors with an added layer of security against potential losses.
Cost of Capital:
The cost of capital should also be taken into consideration when assessing a company’s optimal capital structure. The cost of capital represents the average rate at which a company can borrow money from lenders or issue new shares on the stock market (Subrahmanyam, 2012). Companies that have higher costs of capital may need to adjust their capital structure in order to reduce their financing costs and improve the efficiency of their operations.
The optimal capital structure for a company will depend on its unique circumstances, business risks, market conditions, debt capacity and cost of capital. Companies should always assess these factors before making any changes to their existing capital structure in order to ensure that they are making informed decisions that will benefit their operations in the long run. By taking all of these variables into consideration, companies can optimize their capital structures and maximize shareholder value over time.
References
The capital asset pricing model. (2011). The Capital Asset Pricing Model in the 21st Century, 117-155. https://doi.org/10.1017/cbo9781139017459.006
Panteghini, P. M., Menoncin, F., & Regis, L. (2021). Optimal firm’s dividend and capital structure for mean reverting profitability. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3977546
Subrahmanyam, A. (2012). Comments and perspectives on ‘The capital asset pricing model’. Abacus, 49, 79-81. https://doi.org/10.1111/j.1467-6281.2012.00388.x
2.Factors to Consider When Establishing a Firm’s Capital Structure
Introduction
There are many factors to consider when establishing a firm’s capital structure. The most important factor is the company’s business strategy. The company’s business strategy will dictate what type of financing the company will need to pursue its goals (Ramli et al., 2019). Other important factors to consider include the company’s growth prospects, the nature of its business, its historical financial performance, and the current state of the economy.
Factors to Consider When Establishing a Firm’s Capital Structure
The company’s business strategy is the most important factor to consider when establishing a firm’s capital structure. The company’s business strategy will dictate what type of financing the company will need to pursue its goals. For example, a company that is looking to expand its operations will need to raise more capital than a company that is looking to maintain its current operations (Ramli et al., 2019). The company’s business strategy will also dictate the type of financing that the company will pursue. A company that is looking to expand its operations will need to raise more equity financing than a company that is looking to maintain its current operations.
Another important factor to consider when establishing a firm’s capital structure is the company’s growth prospects. A company with strong growth prospects will be able to raise more capital than a company with weak growth prospects (Matsa, 2018). The nature of the company’s business is also important when establishing a firm’s capital structure. A company that operates in a high-risk industry will need to raise more debt financing than a company that operates in a low-risk industry.
The company’s historical financial performance is also an important factor to consider when establishing a firm’s capital structure. A company with a strong track record of financial performance will be able to raise more capital than a company with a weak track record of financial performance (Cevheroglu-Acar, 2018). The current state of the economy is also an important factor to consider when establishing a firm’s capital structure. A company operating in an economy with strong growth prospects will be able to raise more capital than a company operating in an economy with weak growth prospects.
Conclusion
Considering all the above factors will help establish a clear business purpose for the firm and what you hope to achieve through the capital structure. It will also increase understanding of the different types of financing available, including their pros and cons. Choosing the right mix of debt and equity financing is important to achieve the company’s desired capital structure. The company’s business strategy, growth prospects, and historical financial performance will all play a role in determining the optimal mix of debt and equity financing. The company’s business strategy is the most important factor to consider when establishing a firm’s capital structure. The company’s business strategy will dictate what type of financing the company will need to pursue its goals. The company’s growth prospects, the nature of its business, and historical financial performance are important factors to consider when establishing a firm’s capital structure.
References
Cevheroglu-Acar, M. G. (2018). Determinants of capital structure: Empirical evidence from Turkey. Journal of Management and Sustainability, 8(1), 31. https://doi.org/10.5539/jms.v8n1p31
Matsa, D. (2018). Capital structure and a firm’s workforce. Annual Review of Financial Economics, 10, 387-412. https://doi.org/10.3386/w25125
Ramli, N. A., Latan, H., & Solovida, G. T. (2019). Determinants of capital structure and firm Financial Performance—a PLS-SEM approach: Evidence from Malaysia and Indonesia. The Quarterly Review of Economics and Finance, 71, 148–160. https://doi.org/10.1016/j.qref.2018.07.001

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