The target capital structure

Companies can choose what mix of debt and equity they want to fund their assets, subject to investors’ willingness to provide such funds. And as we’ll see, there are many different mixes of debt and equity, or capital structures — for some companies, like Chrysler Corporation, debt makes up more than 70 percent of their funding, while other firms, like Microsoft, have little or no debt.

In the next few sections, we discuss factors affecting a company’s capital structure, and we conclude that a company should seek to determine its optimal, or best, financing mix. However, you will find that determining the exact optimal capital structure is not a science. After analyzing a number of factors, a company determines a target capital structure that it believes is optimal, which is then used as a guide for future fundraising. This objective may change over time as conditions change, but the Company’s management has a specific capital structure in mind at any point in time and individual financing decisions should be consistent with this objective. If the actual debt ratio is below target, new funds will likely be raised through debt issuance, while if the debt ratio is above target, stocks will likely be sold to bring the company back on target. financial situation.

Capital structure policy involves a trade-off between risk and return. The use of more leverage increases risk to the company’s earnings streams, but higher leverage generally results in a higher expected return; and we know that the higher risk associated with higher debt tends to lower the stock price. At the same time, the higher expected yield makes the stock more attractive to investors, which in turn ultimately increases the stock’s price. Therefore, the optimal capital structure is the 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 incur debt. The greater the company’s business risk, the lower the optimal level of debt.

2. The second key factor is the company’s tax position. A key reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However, when much of a company’s income is already protected from taxes by accelerated depreciation or tax loss carryforwards, its tax rate is low and leverage is not as beneficial as 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 unfavorable terms. Corporate treasurers know that a steady supply of capital is necessary for stable operations, which in turn is critical to long-term success. They also know that when money is tight in the economy or when a company is experiencing operating difficulties, a strong balance sheet is needed to attract funding from financiers. Therefore, it can be beneficial to issue equity to strengthen the company’s capital base and financial stability.

4. The fourth debt determinant has to do with the manager’s attitude (conservatism or aggressiveness) towards borrowing. Some managers are more aggressive than others, so some companies are more inclined to use debt to grow profits. This factor does not affect the optimal or value-maximizing capital structure, but it does affect the target capital structure that a company actually builds.

These four points largely determine the target capital structure, but as we shall see, operating conditions can cause the actual capital structure to differ from the target capital structure at any time. For example, as discussed in the management perspective at the beginning of the chapter, Unisys’ debt/asset ratio was clear. well above its target and the company has taken some significant corrective actions in recent years to improve its financial condition.