Factors Affecting Capital Structure Decisions

The ideal capital structure is a mix of stock and debt that reduces the firm’s weighted average cost of capital. The following factors affect the capital structure and the use of leverage by management:

• Capital structure policies and targets
• Capital investment financing
• Market conditions
• Asymmetric information

Capital Structure Policies and Target Capital Structures

A company’s target capital structure is one that achieves an optimal mix of debt and equity. Due to the difficulty of estimating a company’s cost of equity and the cost of financial distress, capital structure policies tend to be debt-oriented, setting the company’s borrowing limits, e.g., “debt as a maximum of X% of total capital.”

Not all companies have capital structure policies; however, they are crucial for frequent borrowers due to the risks associated with too much leverage. In some industries, a capital structure mix may be dictated by regulators.

Debt Rating

Debt rating is a system of measuring a company’s ability to manage and pay its debt practically. As the debt rises, the rating agencies tend to lower the ratings of the company’s debt to reflect higher credit risk. A lower rating signifies higher risk to both equity and debt capital providers, who demand higher returns. Rating agencies such as Moody’s and Fitch perform financial analyses of the company’s ability to pay its debt, as well as an analysis of the bond’s indenture.

The agencies assess information regarding the bond and issuer, including the bond’s characteristics and indenture, and provide investors with an assessment of the company’s ability to pay. Managers consider the company’s debt rating in their capital structure policies. Because the cost of capital is tied directly to the bond ratings, managers must be aware of their company’s bond ratings. The cost of debt increases significantly when a bond rating drops from investment grade to speculative grade.

Market Value vs. Book Value

While the market value of equity and debt is used to establish the ideal capital structure, company capital structure targets frequently utilize book value instead for the following reasons:

• Market values can change dramatically, but they rarely have an impact on the optimum level of borrowing.
• The amount and types of capital invested by the company, not the company itself, is of main significance to management.
• The capital structure policy ensures that management can borrow quickly and at a cheap cost. Lenders and rating agencies use book values of debt and equity in their calculation measures.

Financing Capital Investments

Key financing decisions are typically tied to investment spending. Management will examine the asset’s or investment’s characteristics and requirements at the time of financing, and the company’s overall capital structure after the investment has been made.

Assets suited for leverage include real estate and infrastructure assets, which are generally easy to market cash-generative, and typically regarded as strong collateral by lenders. In contrast, those with minimal tangible assets are less attractive to lenders.

Companies mitigate risk by matching the cash flows and maturity structures of their assets and liabilities. Asset liability misalignment increases the risk of default and cost of capital for companies.

Financing may already be in place for some ventures. An example would be the purchase of an established business.

Foreign investments are frequently financed in large part with debt, either to hedge currency risk by borrowing in the same (foreign) currency as revenues produced or to cut taxes if tax rates are higher in the foreign jurisdiction.

Market Conditions

When selecting when, how much, and what type of capital to issue, managers pay close attention to the price of their company’s shares and market interest rates on its loans.                

A firm’s debt cost equals the risk-free rate plus a risk premium unique to the organization. Above the risk-free benchmark rate, the risk premium, or credit spread, reflects issuer-specific risk considerations as well as broader credit market circumstances. Debt costs are lower for more creditworthy enterprises with robust and predictable cash flows, lower risk, and higher debt ratings. On the other hand, less profitable corporations have higher debt costs due to higher cash flow volatility and/or predictability, higher risk, and lower debt ratings.

Information Asymmetries and Signaling

Managers have more information about a company’s performance and prospects—including future investment opportunities—than outsiders, resulting in asymmetric information—an unequal distribution of information.

Because there is a greater potential for conflicts of interest, debt and equity capital providers demand higher returns from companies with increased asymmetry in information. In other words, investors know that management has access to more information about the business and will use this information when raising capital.

Companies will avoid equity financing for retained earnings or issuing debt. The pecking order theory suggests that managers will prefer financing from internally generated funds, then debt, and finally equity. Additionally, managers will tend to issue equity if they believe their stock is overvalued.

Agency Costs

Internal costs incurred due to competing interests of shareholders (principals) and the management team are agency costs (agents). Items such as subsidized dinners, a corporate jet fleet, and chauffeured limousines are examples of “perquisite consumption” that executives might lawfully authorize for themselves at a cost to shareholders.

The costs arising from this conflict of interest have been called the agency costs of equity. Certain actions are taken to mitigate this risk, such as requiring audited financial statements, holding an annual meeting, using noncompete employment contracts and insurance to guarantee performance.

Agency theory predicts that a reduction in agency costs of equity results from an increase in the use of debt. The more financially leveraged a company is, the less room management has to take on more debt or spend money foolishly.

Question

A lower credit rating of a company’s debt most likely signifies:

1. lower risk for equity and debt investors.
2. lower returns demanded by equity and debt investors.
3. higher risk for equity and debt investors.

Solution 

The correct answer is C.

A lower credit rating signifies higher risk for the company’s investors, who demand higher returns.

A and B are incorrect: A lower credit rating signifies higher risk and, as such, higher returns demanded by equity and debt investors