Explain Factors Affecting Capital Structure

Both internal and external forces influence a corporation’s capital structure, varying among countries and sectors. These factors include:

$$ \begin{array}{l|l}
\text{Internal factors} & \text{External factors} \\ \hline
\text{Business model characteristics} & \text{Market conditions} \\ \hline
\text{Cash flows and Profitability} & \text{Regulatory constraints} \\ \hline
\text{Asset types and Ownership} & \text{Industry/peer factors} \\ &
\end{array} $$

Determinants of the Amount and Type of Financing Needed

The type of financing and the total amount needed depend on the issuer’s position in the corporate life cycle and business model.

Capital-Intensive Business

Capital-intensive businesses require significant assets to operate. They have high capital expenditures relative to sales, low asset turnover, and high working capital needs compared to sales.

Many businesses begin as vertically integrated and capital-intensive, but over time, they separate the capital-intensive parts from the service or customer-facing aspects, shifting to contractual relationships rather than ownership.

For certain businesses, like banks, government regulations require maintaining a specific proportion of equity as assets. This increases the weighted average cost of capital (WACC) due to the higher reliance on equity financing.

Capital-Light Businesses

Some service businesses, like those in the technology sector, have low capital requirements. These asset-light businesses have low capital expenditures relative to sales and high fixed asset turnover. Their assets typically consist of excess cash and intangibles. This can be attributed to the following factors:

• They operate a network for other companies that own the assets, so they don’t need to seek financing from capital markets.
• Customers are charged upfront, or the company has a negative or short cash conversion cycle, eliminating the need for external working capital financing.
• The company may compensate employees with stock, which they are willing to accept due to the company’s rising stock price, reducing the need for cash.

• If a company is capital-light and profitable in its early stages, it may not need external financing unless management decides it’s necessary.

Corporate Life Cycle

The maturity, capital intensity, market position strength, and the stability and nature of a company’s operation all influence its capital structure and ability to support debt.

As a general rule, companies begin as capital consumers; that is, they burn cash. Cash flows then go from negative to positive, and business risk declines as they develop, allowing for greater use of leverage. At this stage, debt becomes a more significant component of its capital structure. Capital markets connect companies with investors whose requirements vary. Capital that cannot be obtained through borrowing must be obtained through equity.

There is a link between a company’s life-cycle stage, cash flow characteristics, and its ability to support debt. A company’s life-cycle stages include start-up, growth, and maturity.

Capital Structure and Company Life Cycle

Start-ups

In the start-up stage, companies are cash consumers. Revenues are zero to minimal, and the business risks are high. Companies in the start-up stage will use equity financing instead of debt because of the high uncertainty of cash flow generation. This equity is sourced privately (from founders, employees, and venture capitalists) rather than in public markets (such as IPO).

Leases (such as office and retail real estate) and convertible debt might be accessible sources of debt financing. Convertible debt allows investors to convert debt to equity in the future at a predetermined price.

Growth

As a company exits the start-up stage, its revenues increase because of strong demand and rapid growth. However, free cash flow, while improving, may still be negative. This is due to the substantial investments required to support and sustain the growth and expansion.

At this stage, business risk declines as a company establishes a customer and supplier base. The company also becomes more attractive to lenders since cash flows and its asset base can be used as security. Companies will begin using debt, but equity remains the predominant source of capital.

Mature Businesses

At this stage, revenue growth may slow down or start to decline, but it becomes more predictable. Free cash flows are positive and steady, allowing the company to manage low-cost, often unsecured debt. For the company, debt financing is typically more appealing than equity financing because it is less expensive.

In practice, large, mature public companies commonly employ significant leverage. Due to the tax-deductibility of interest expense, debt is a vital component of the “optimal” capital structure once an organization can support it.

Over time, mature organizations often deleverage, decreasing debt as a percentage of total capital. Deleveraging occurs due to ongoing cash flow generation, and equity values improve over time due to share price gain. Companies may choose to execute share buybacks to mitigate this deleveraging, reducing the equity in their capital structure.

Determinants of the Costs of Debt and Equity

Investors’ assessments of issuer-specific and top-down factors determine the cost of equity and debt in financial markets. Despite the cost of equity being higher than the cost of debt, they are influenced by the same factors and thus move together because they claim the same cash flows.

These factors include:

Top-Down Factors

Top-down factors include financial market conditions and industry conditions.

Economic Conditions

The prevailing economic environment can heavily impact the anticipated returns for debt and equity investors in either private or public sectors. For instance, macroeconomic and specific country-related factors, like growth rate, inflation, monetary strategies, and currency value fluctuations, can increase interest rates on sovereign government debt and credit spreads for different issuers.

Moreover, with the looming threat of a recession, lenders may require much larger premiums from borrowers due to the rising chances of a loan default. This trend is especially noticeable in cyclical sectors.

Lastly, from the perspective of equity investors, companies aim to take loans when the interest rates are low and opt for equity releases when the stock prices are high.

Industry Conditions

The industry where a company operates may influence its cost of capital. Typically, a company’s vulnerability to economic variables is based on the type of products or services it offers.

For instance, consider a case of fluctuating oil prices. When oil prices rise, oil producers might benefit from narrower credit spreads, and investors might be more inclined to up their financial stakes in these firms. Conversely, for businesses like airlines, where fuel constitutes a significant cost, increased oil prices might widen their credit spreads and dampen investor enthusiasm due to anticipated higher operating costs.

Issuer-Specific Factors

Issuer-specific factors cover the risk and return profile of an issuer. By considering the risk-return of an issuer debt and equity, investors can modify their expected returns based on fundamental rates or general averages by examining various risk elements, which include:

1. Interest coverage and Financial leverage. Interest coverage and financial leverage are also considered because a company with substantial debt might struggle to take on additional borrowing. Furthermore, a high debt level for shareholders indicates that many other claims take precedence over their interests.Interest coverage is calculated as follows:

   $$ \text{Interest coverage}=\frac{\text{Profit before interest and taxes}}{\text{Interest expense}} $$

   A higher interest coverage ratio shows a company’s good financial health, as it can comfortably cover its interest payments. Conversely, a ratio below 1 signifies potential financial strain, as the company may struggle to meet interest expenses, raising concerns for lenders and investors.

   On the other hand, financial leverage is calculated as follows:

   $$ \text{Financial Leverage}=\frac{\text{Total Debt}}{\text{Total Equity}} $$

   A higher debt-to-equity ratio indicates that a company has a higher proportion of debt in its capital structure, implying more financial leverage. Conversely, a lower ratio suggests the company relies more on equity financing, indicating less financial leverage.

2. Profitability Risks. Profit margin stability is also a crucial factor determined by a firm’s proportion of variable or fixed costs. The operating leverage of a company is used to measure the stability of profit margins:$$ \text{Operating leverage}=\frac{\text{Fixed costs}}{\text{Total costs}} $$

   Firms with higher operating leverage see a greater fluctuation in cash flow and profits for a specific change in revenue compared to companies with lower operating leverage.

3. Sales Risks. Other factors held constant, investors are more confident in firms with stable, growing, and predictable revenues and thus will lend to such firms at a lower cost.
4. Collateral/Type of Assets Owned by the Firm. The assets central to a company’s business model play a crucial role. Typically, assets like real estate, vehicles, aircraft, and reliable customer receivables, which can act as strong collateral or are liquid and cash-generating, allow for more debt usage.

Question

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

1. Lower risk for equity and debt investors.
2. Higher risk for equity and debt investors.
3. Lower returns are demanded by equity and debt investors.

Solution

The correct answer is B.

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

A and C are incorrect. A lower credit rating signifies higher risk and, as such, higher returns that equity and debt investors demand.