Capital Structure Theories^303
government; based on international parity price In effect, building ships turned out to be
unviable for the yard. Further, HSL's overtime bill soared up, being a highly overstaffed
company. It had 11,000 workers in 1990. A lack of strategy paved way for unchecked
downfall. Orders continued declining, and became almost nil by 1988 and 1989. To tide over
this, company borrowed funds, and since operating performance did not improve, the company
fell deeper and deeper into debt trap.HSL is technically insolvent. The capital restructuring
plan are on to put the company back on its feet.Source: Messiasl Lionel, Hindustan Shipyard: A Dead Weight Debt, The Economic Times, 15 Feb, 1994.
Sales of the consumer goods industries show wide fluctuations; therefore. they do not
employ a large amount of debt. On the other hand, the sales of public utilities are quite
stable and predictable. Public utilities, therefore, employ a large amount of debt to
finance their assets. The expected growth in sales also affects the degree of leverage.
The greater the expectation of growth, the greater the amount of external financing
needed since it may not be possible for the firm to cope up with growth through internally
generated funds. A number of managers consider debt to be chapter and easy to raise.
The growth firms, therefore, may usually employ a high degree of leverage. Companies
with declining sales should not employ debt in their capital structures as they would find
difficulty in meeting their fixed obligations. Non-payment of fixed charges can force a
company into liquidation. It may be noted that sales growth and stability is just one
factor in the leverage decision; many other factors would dictate the decision. There
are instances of a large number of high growth firms employing no or small amount of
debt.
Cost of Capital and Valuation Approach
The cost of a source of finance is the minimum return expected by its suppliers. The
expected return depends on the degree of risk assumed by investors. A high degree of
risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate
of interest is fixed and the company is legally bound to pay interest whether it makes
profits or not. For ordinary shareholders, the rate of dividends is not fixed and the board
of directors has no legal obligation to pay dividends eiren if the profits are made by the
company. The loan of debt-holders is returned within a prescribed period, while
shareholders will have to share the residue only when the company is wound up. This
leads one to conclude that debt is a cheaper source of funds than equity. This is generally
the case even when taxes are not considered. The tax deductibility of interest charges
further reduces the cost of debt. The preference share capital is also cheaper than
equity capital, but not as cheap as debt. Thus, using the component, or specific, cost of
capital as a criterion for financing decisions and ignoring risk, a firm would always like
to employ debt since it is the cheapest source of funds.