PART 5 Capital Structure and Dividend Policy
whereas if the debt ratio is above the target, equity will be used. The target may
change over time as conditions change; but at any given moment, management
generally has a speci! c debt ratio in mind.
Setting the capital structure involves a trade-off between risk and return:
- Using more debt will raise the risk borne by stockholders.
- However, using more debt generally increases the expected return on equity.
The higher risk associated with using more debt tends to lower the stock price, but
the higher debt-induced expected rate of return raises it. Therefore, we seek to! nd the
capital structure that strikes a balance between risk and return so as to maximize the stock
price.
Four primary factors in" uence capital structure decisions:
- Business risk, or the riskiness inherent in the! rm’s operations if it used no
debt. The greater the! rm’s business risk, the lower its optimal debt ratio.
- The! rm’s tax position. A major reason for using debt is that interest is tax
deductible, which lowers the effective cost of debt. However, if most of a! rm’s
income is already sheltered from taxes by depreciation tax shields or interest
on currently outstanding debt or tax loss carry-forwards, its tax rate will be
low. In this case, additional debt would not be as advantageous as it would be
to a! rm with a higher effective tax rate.
- Financial " exibility, or the ability to raise capital on reasonable terms even
under adverse market conditions. Corporate treasurers know that a steady
supply of capital is necessary for stable operations, which is vital for long-run
success. They also know that when money is tight in the economy or when a
! rm is experiencing operating dif! culties, it is easier to raise debt than equity
capital and lenders are more willing to accommodate companies with strong
balance sheets. Therefore, the! rm’s potential future need for funds and the
consequences of a funds shortage combine to in" uence its target capital
structure—the greater the probability that capital will be needed and the worse
the consequences of not being able to obtain it, the less debt the! rm should
have on its balance sheet.
- Managerial conservatism or aggressiveness. Some managers are more aggressive
than others; hence, they are more willing to use debt in an effort to boost prof-
its. This factor does not affect the true optimal, or value-maximizing, capital
structure; but it does in" uence the! rm’s target capital structure.
Those four points largely determine a! rm’s target capital structure, but operating
conditions can cause its actual capital structure to vary from the target. For exam-
ple, a company’s actual stock price might for some reason be well below the intrin-
sic value as seen by management. In this case, management would be reluctant to
issue new stock to raise capital; so it might use debt! nancing even though this
would cause the debt ratio to rise above the target level. However, the company
would probably take steps to return the capital structure to its target level as soon
as the stock price approached its intrinsic value.
SEL
F^ TEST De! ne the optimal capital structure and di" erentiate it from the target capi-
tal structure.
Name four factors that in# uence a! rm’s target capital structure.
In what sense does setting the target capital structure involve a trade-o"
between risk and return?
Why might market conditions cause a! rm’s actual capital structure to vary
from its target level?
