Designing an Optimum Capital Structure
The optimal capital structure refers to a proportion of debt and equity at which the marginal real cost of each available source of financing is same. This is also viewed as a capital structure that maximizes market price of shares and minimizes the overall cost of capital of the firm.
Theoretically the concept of optimal capital structure can easily be explained, but in operational terms it is difficult to design an optimal capital structure because of a number of factors, both quantitative and qualitative, that influence the optimum capital structure.
Moreover the subjective judgment of the finance manager of the firm is also an influencing factor in designing the optimum capital structure of a firm. Designing the capital structure is also known as capital structure planning and capital structure decision.
While designing an optimum capital structure the following factors are to be considered carefully:
1. Profitability:
An optimum capital structure must provide sufficient profit. So the profitability aspect is to be verified. Hence an EBIT-EPS analysis may be performed which will help the firm know the EPS under various financial alternatives at different levels of EBIT. Apart from EBIT-EPS analysis the company may calculate the coverage ratio to know its ability to pay interest.
2. Liquidity:
Along with profitability the optimum capital structure must allow a firm to pay the fixed financial charges. Hence the liquidly aspect of the capital structure is also to be tested. This can be done through cash flow analysis. This will reduce the risk of insolvency. The firm will separately know its operating cash flow, non-operating cash flow as well as financial cash flow. In addition to the cash flow analysis various liquidity ratios may be tested to judge the liquidity position of the capital structure.
3. Control:
Another important aspect in designing optimum capital structure is to ensure control. The supplies of debt have no role to play in managing the firm; but equity holders have right to select management of the firm. So more debt means less amount of control by the supplier of funds. Hence the management will decide the extent of control to be retained by themselves while designing optimum capital structure.
4. Industry Average:
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The firm should be compared with the other firms in the industry in terms of profitability and leverage ratios. The amount of financial risk borne by other companies must be considered while designing the capital structure. Industry average provides a benchmark in this respect. However it is not necessary that the firm should follow the industry average and keep its leverage ratio at par with other companies; however, the comparison will help the firm to act as a check valve in taking risk.
5. Nature of Industry:
The management must take into consideration the nature of the industry the firm belongs to while designing the optimum capital structure. If the firm belongs to an industry where sales fluctuate frequently then the operating leverage must be conservative.
In case of firms belonging to an industry manufacturing durable goods, the financial leverage should be conservative and the firm can depend less on debt. On the other hand, firms producing less expensive products and having lesser fluctuation in demand may take an aggressive debt policy.
6. Maneuverability in Funds:
There should be wide flexibility in sourcing the funds so that firm can adjust its long-term sources of funds if necessary. This will help firm to combat any unforeseen situations that may arise in the economic environment. Moreover, flexibility allows firms to avail the best opportunity that may arise in future. Management must keep provision not only for obtaining funds but also for refunding them.
7. Timing of Raising Funds:
Timing is yet another important factor that needs to be considered while raising funds. Right timing may allow the firm to obtain funds at least cost. Here the management needs to keep a constant vigil on the stock market, the government’s steps towards monetary and fiscal policies, market sentiment and other macro economic variables. If it is found that borrowed funds became cheap the firm may move to issue debt securities. It should be noted here that the firm must operate under its debt capacity while designing its capital structure.
8. Firm’s Characteristics:
The size of the firm and creditworthiness are important factors to be considered while designing its capital structure. For a small company the management cannot depend much on the debt because its creditworthiness is limited—they will have to depend on equity.
For a large concern, however, the benefit of capital gearing may be availed. Small firms have limited access to various sources of funds. Even investors are reluctant to invest in small firms. So the size and credit standing also determine capital structure of the firm.
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