The target capital structure

Companies can choose any combination of debt and equity they want to finance their assets, subject to the willingness of investors to provide such funds. And, as we’ll see, there are many different combinations of debt and equity, or equity structures: At some companies, like Chrysler Corporation, debt accounts for more than 70 percent of financing, while other companies, like Microsoft, have little or none. debt.

In the next few sections, we discuss the factors that affect a company’s capital structure and conclude that a company should try to determine what its optimal or best financing mix should be. But you will find that determining the exact optimal capital structure is not a science, so after analyzing a number of factors, a company sets a target capital structure that it believes is optimal, which is then used as a guide to raise funds in the future. . This objective may change over time as conditions vary, but at any given time the company’s management has a specific capital structure in mind and individual financial decisions must be consistent with this objective. If the actual debt ratio is below the target level, new funds are likely to be raised through debt issuance, while if the debt ratio is above the target, shares are likely to be sold to get the company back on track. in line with target debt/target. asset ratio.

The capital structure policy implies a compromise between risk and return. Using more debt increases the risk to the firm’s earnings stream, but a higher proportion of debt generally leads to a higher expected rate of return; and we know that the increased risk associated with increased debt tends to lower the share price. However, at the same time, the higher expected rate of return makes the stock more attractive to investors, which, in turn, ultimately increases the stock price. Therefore, the optimal capital structure is one that strikes a balance between risk and return to achieve our ultimate goal of maximizing share price.

Four main factors influence capital structure decisions:

1. The first is the company’s business risk, or the risk that would be inherent in the company’s operations if it did not use debt. The higher the company’s business risk, the lower the optimal amount of debt.

2. The second key factor is the tax position of the company. One of the main reasons for using debt is that the interest is tax deductible, which reduces the effective cost of debt. However, if much of a company’s income is already shielded from taxes by accelerated depreciation or accumulated tax losses, its tax rate will be low and debt will not be as advantageous as it would be for a company with a higher effective tax rate. .

3. The third important consideration is financial flexibility, or the ability to raise capital on reasonable terms in adverse conditions. Corporate treasurers know that a constant supply of capital is needed for stable operations, which, in turn, are vital to long-term success. They also know that when money is tight in the economy, or when a company experiences operating difficulties, a strong balance sheet is needed to raise funds from capital providers. Therefore, it may be advantageous to issue shares to strengthen the capital base and financial stability of the company.

4. The fourth determinant of debt has to do with the managerial attitude (conservatism or aggressiveness) with respect to indebtedness. Some managers are more aggressive than others, which is why some companies are more inclined to use debt in an effort to increase profits. This factor does not affect the optimal or value-maximizing capital structure, but it does influence the target capital structure that a company actually sets.

These four points largely determine the target capital structure, but as we will see, operating conditions can cause the actual capital structure to vary from the target at any given time. For example, as discussed in the Management Perspective at the beginning of the chapter, Unisys’ debt-to-asset ratio has clearly been . much higher than its target, and the company has taken some significant corrective actions in recent years to improve its financial position.