One Advantage Of Debt Financing Over Equity Financing Is The: The Target Capital Structure

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The Target Capital Structure

Firms can choose whatever mix of debt and equity they wish to finance their assets, subject to the willingness of investors to provide such funds. And, as we shall see, there are very different mixes of debt and equity or capital structure—in some firms, such as Chrysler Corporation, more than 70 percent of debt is financing, while in other firms, such as Microsoft, little or no debt.

In the next few sections, we discuss the factors that affect a firm’s capital structure, and we conclude that a firm should try to determine what its optimal, or best, mix of financing should be. However, you will find that determining the exact optimal capital structure is not a science, so after analyzing many factors, the firm establishes a target capital structure that it believes is optimal, which is used as a guide for future fund raising. . This goal may change over time as circumstances vary, but at any given moment the firm’s management has a specific capital structure in mind, and individual financing decisions must be consistent with this goal. If the actual debt ratio is below the target level, new funds can be raised by issuing debt, while if the debt ratio is higher than the target, the firm can sell stock to bring back the target debt. Asset ratio.

Capital structure policy involves a trade-off between risk and return. Using more debt increases the riskiness of a firm’s income stream, but a higher ratio of debt generally leads to a higher expected rate of return; And, we know that the higher risk associated with greater debt lowers stock prices. At the same time, however, a higher expected rate of return makes the stock more attractive to investors, which ultimately increases the stock price. Therefore, the optimal capital structure is to strike a balance between risk and return to achieve our ultimate goal of maximizing stock value.

Four primary factors influence capital structure decisions:

1. The first is the firm’s business risk, or the risk inherent in the firm’s operations if debt is not used. The higher the firm’s business risk, the lower the amount of debt that is optimal.

2. The second key factor is the firm’s tax status. A major reason for using debt is that the interest is tax deductible, which lowers the effective cost of debt. However, if much of the firm’s income is already shielded from taxes by accelerated depreciation or tax loss carryforwards, its tax rate will be lower, and debt will not be as beneficial to a firm with a higher effective tax rate.

3. A third important consideration is financial flexibility, or the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers know that stable operations require a steady supply of capital, which, in turn, is critical to long-term success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, obtaining funds from suppliers of capital requires a strong balance sheet. Therefore, equity issuance can be beneficial to strengthen the firm’s capital base and financial stability.

4. The fourth credit-determining factor relates to managerial attitude (conservatism or aggressiveness) with respect to credit. Some managers are more aggressive than others, so some firms are more inclined to use debt in an effort to increase profits. This factor does not affect the optimal, or cost-maximizing, capital structure, but it does affect the target capital structure that the firm actually establishes.

These four points largely determine the target capital structure, but, as we will see, operating conditions may cause the actual capital structure to differ from the target at any given time. For example, as discussed in the managerial perspective at the beginning of the chapter, Unisys’ debt/asset ratio is clearly It is well above its target, and the company has taken some significant corrective actions in recent years to improve its financial position.

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