Companies can choose the mix of equity and debt they want to finance their assets, depending upon the willingness of lenders to provide these funds. Within thousands of companies, there exists a mix of equity and debt, or capital structures- in some companies such as Microsoft, there is negligible debt, whereas firms such as Chrysler Corporation may have debt accounts for more than 60 percent of their financing.
So a capital structure policy actually involves a sort of trade-off between the risks and returns. The riskiness of firm‘s earning stream increases with the increase in debt, but sometimes higher proportion of debt may even lead to higher rate of return, but higher risk associated with debt also reduces the stock price. On the other hand, higher than expected return may lead to an increase in the stock price. Therefore, an optimal capital structure is one that strikes a fine balance between risk and return for achieving the ultimate aim of increasing the price of stock.
Some major factors that may influence the capital structure decisions are:
• The first is the riskiness associated with the firm’s operations if it uses not debt. The higher the firm’s risk, the lower is the amount of debt. However, this may also affect the profitability of the company.
• The second important factor is the financial ability or flexibility of the company to raise capital on reasonable terms under difficult conditions.
• The third important factor is firm’s current tax position. The main reason for using a debt is that its interest is tax deductible, which helps in lowering the cost of debt. However, if majority of firm’s income is fully sheltered from taxes due to accelerated depreciation, or any tax loss carryforwards, then its tax rate may be low, and this debt won’t be as beneficial as it would be to a company with a much higher tax rate.
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