DESIGNING CAPITAL STRUCTURE
The preceding chapter, focusing on the theoretical relationship between capital structure, cost of capital and valuation, has shown that although the empirical evidence is not conclusive, theoretically a judicious combination of debt and equity does affect the cost of capital as also the total value of the firm. There is, in other words, an optimum capital structure. The capital structure is said to be optimum when the marginal real cost (explicit as well as implicit) of each available source of financing is identical.With an optimum debt and equity mix, the cost of capital is minimum and the market price per share (or total value of the firm) is maximum.The use of debt in capital structure or financial leverage has both benefits as well as costs. While the principal attraction of debt is the tax benefit, its cost is financial distress and reduced commercial profitability.
The term financial distress includes a broad spectrum of problems ranging from relatively minor liquidity shortages to bankruptcy. The problem of financial distress will magnify with an increase in financial leverage. Beyond a certain point, the expected cost of financial distress will outweigh the tax benefit. A fum is, thus, concerned with a trade-off between risk and return emanating from the use of debt. A proper balance between the two is, therefore, called for Given the objective of maximization of shareholders wealth, the need for an optimal capital structure cannot, therefore, be overemphasized. In operational terms, every firm should try to design such a capital structure. But the determination Of an optimum capital structure is a formidable task. It should be clearly understood that identifying the precise percentage of debt that will maximize price per share is almost impossible. It is possible, however, to determine the approximate proportion of debt to use in the financial plan in conformity with the objective of maximizing share prices.
In theory, one can speak of an optimum capital structure, but, in practice, it is very difficult to design one. There an significant variations among industries as also among individual companies within the same industry in respect of capital structure. This is so because there are a host of factors, both quantitative and qualitative, including subjective judgement of financial managers which determine the capital structure of a firm. These factors are highly complex and cannot fit entirely into a theoretical framework. From the operational standpoint, therefore, what should be attempted is an appropriate capital structure, given the facts of a particular case.
The present chapter which focuses on determining the appropriate mix of debt to be used along with equity in the capital structure discusses the important factors which have a bearing on designing capital structure of a firm. The terms designing capital structure, capital structure decision, factors determining capital structure and capital structure planning are used interchangeably here.
It may be noted, at the outset, that there are certain common, and often, conflicting considerations involved in determining the methods of financing assets because the position of each company is different. Accordingly, the weight given to various factors also varies widely, according to conditions in the economy, the industry and the company itself. Above all, the freedom of management to adjust.the mix of debt and equity in accordance with these criteria IS limited by the availability of the various types of debt to have an appropriate capital structure, but the debt may be available to the company because the suppliers of the funds may think that it with involve too much financial risk for them. Consequently, the plans that management ultimately makes in the light of these considerations, often involve a compromise between the desires and conditions imposed by the suppliers of funds. Moreover, none of the factors by itself is completely satisfactory, But, collectively, they provide sufficient information for taking rational decisions. The key factors governing the capital structure decisions are (i) profitability aspect, (ii) liquidity aspect,(iii) control. (iv) leverage ratios in industry. (v) nature of industry, (vi) consultation with investment banks/lenders, (vii) commercial strategy. (viii) timing, (ix) company characteristics and (x) tax planning.