Target capital structure Essay
Different industries have different capital structure which is based on the risk associated with its operations. The four factors that may influence capital structure decision are:Business Risk: Risk is the primary subject area of all the businesses. The greater the firm’s business risk, the lower would be the probability of an optimal debt ratio.
Tax Position: Use of debt is favorable to businesses in the sense that interest is tax deductible, which lowers the effective cost of debt. If the firm’s income is already suffering from tax deductions by depreciation tax shields, by interest on current debt then additional debt will not rescue the course of the firm with a higher effective tax rate.Financial Flexibility: Raising capital under rough business conditions is quite a tedious task.
Although to cope with this scenario directors of the company know that steady flow of capital is pivotal for the company’s survival. Incase of economic recession, when the company might require funds to run its operational activities the capital providers provide funds to those firms whose balance sheet reflects stronger financial position. On this whole scenario we can say that the shortage of funds will bear a consequence not only on the present but also on the future needs.Managerial Business Strategy: Firm’s aggressive and conservative business policies may also have an impact on the firm’s optimal capital structure. Some firms favor the use of debt for generating its business profits, which is an aggressive business strategy.
This factor doesn’t have an implication on the true optimal capital structure, but it does influence on the decision making of financial managers to determine the target capital structure.REFERENCE· Brigham, E., Joel Houston, Eugene Brigham (2001). Fundamentals Of Financial Management. Harcourt College Publishers.