Yes,I strongly agree with the statement that capital structure is acomplex area in making financial decisions. This is because it has asignificant impression to the profitability of the company. However,the most difficult task for the financial managers is determining theoptimal capital structure to apply in their business especially whenfunding new projects. To address this issue, several theories havebeen provided to help the managers in the decision-making process.Pecking order theory provides that financing should start withretained earnings and if this is not sufficient, then the firm shouldseek funds from debt and if still not work, then new equity shouldalways be the last resort. The cost of capital will differ from onefirm to the other depending on their capital structure. Taking anexample of two firms in the same industry say firm A and firm B witha leverage ratio of 65% and 40% respectively, firm A will have toincur higher fixed cost than firm B to pay for the interests chargedon its debt. This will therefore imply that the firm will have alower profit margin as compared with firm B.
Wehave already seen that capital leverage is associated with fixed costof financing. Therefore, the amount of leverage in the capitalstructure of a firm would increase its risk and lower itsprofitability. Debt and external equity increase the cost of capital.However, a firm may decide to fund their new projects with thisexternal equity or even debt. The capital structure decisions aretherefore based on various factors which include revenuereliability, tax incentive, risk management, management preferences,etc. For example, a firm may prefer using debt rather than itsreserve to enhance tax planning. This is because the interest chargedon debt is tax allowable and hence this will help in reducing the taxliability of the firm.
Post3Qualitativefactors to consider in capital structure decisions
YesI do agree with this post that managers need to consider not onlyquantitative factors but also the qualitative factors. Qualitativeissues involve the factors that may have a direct impact on thechoice of the firm’s capital structure. Someof this factors include organizational culture, total qualitymanagement, market share, organization goals/objectives, marketcondition, organizational environment among others. Qualitativefactors play a great role while making capital structure decisions.For example, a firm policy may provide that all its project should befinanced 50% from external sources. This implies that the decisionmaker is limited to this policy while making capital structuredecisions.
Atsometimes, the capital structure decisions are limited by the agencyproblem. Finance managers act as agents of the stockholders. Theirmain role is to mediate between the business owner (the stockholders)and the lenders. However an agency problem may arise whereby themanagers try to serve for their own interest which is contrary totheir principals or the owners. For example, a manager can favour aparticular lender for his interest but not to the benefit of thefirm. Managers tend to engage in such activities so as to increasetheir benefits in the form of agency cost. Therefore, capitalstructure decision can be influenced by agency problem.
Gitman,C.J., Zutter, C.J Principles of Managerial Finance 14th EditionPearson Education.
DouglassG. (2014).Corporate financial management 4thedition.Britain: Pearson Education.