542 PART 4 Long-Term Financial Decisions
TABLE 12.16 Important Factors to Consider in Making Capital Structure
DecisionsConcern Factor DescriptionBusiness risk Revenue stability Firms that have stable and predictable revenues can more safely
undertake highly leveraged capital structures than can firms with
volatile patterns of sales revenue. Firms with growing sales tend to
benefit from added debt because they can reap the positive benefits
of financial leverage, which magnifies the effect of these increases.
Cash flow When considering a new capital structure, the firm must focus on its
ability to generate the cash flows necessary to meet obligations. Cash
forecasts reflecting an ability to service debts (and preferred stock)
must support any shift in capital structure.
Agency costs Contractual obligations A firm may be contractually constrained with respect to the type of
funds that it can raise. For example, a firm might be prohibited from
selling additional debt except when the claims of holders of such
debt are made subordinate to the existing debt. Contractual con-
straints on the sale of additional stock, as well as on the ability to
distribute dividends on stock, might also exist.
Management preferences Occasionally, a firm will impose an internal constraint on the use of
debt to limit its risk exposure to a level deemed acceptable to man-
agement. In other words, because of risk aversion, the firm’s man-
agement constrains the firm’s capital structure at a level that may or
may not be the true optimum.
Control A management concerned about control may prefer to issue debt
rather than (voting) common stock. Under favorable market condi-
tions, a firm that wanted to sell equity could make a preemptive
offeringor issue nonvoting shares(see Chapter 7), allowing each
shareholder to maintain proportionate ownership. Generally, only in
closely held firms or firms threatened by takeover does control
become a major concern in the capital structure decision.
Asymmetric information External risk assessment The firm’s ability to raise funds quickly and at favorable rates
depends on the external risk assessments of lenders and bond raters.
The firm must therefore consider the impact of capital structure
decisions both on share value and on published financial statements
from which lenders and raters assess the firm’s risk.
Timing At times when the general level of interest rates is low, debt financ-
ing might be more attractive; when interest rates are high, the sale of
stock may be more appealing. Sometimes both debt and equity capi-
tal become unavailable at what would be viewed as reasonable
terms. General economic conditions—especially those of the capital
market—can thus significantly affect capital structure decisions.Review Questions
12 – 14 Why do maximizing EPS and maximizing valuenot necessarily lead to
the same conclusion about the optimal capital structure?
12 – 15 What important factors in addition to quantitative factors should a firm
consider when it is making a capital structure decision?