Factors Affecting Capital Structure

Both internal and external forces influence a corporation’s capital structure, and it varies among countries and sectors. These factors include:
$$
\begin{array}{l|l}
\textbf { Internal Factors } & \textbf { External Factors } \\
\hline \text { Business model characteristics } & \text { Market conditions } \\
\hline \text { Existing leverage } & \text { Regulatory constraints } \\
\hline \text { Corporate tax rate } & \text { Industry/peer firm leverage } \\
\hline \text { Capital structure policies, guidelines } & \\
\hline \text { Company life cycle stage } & \\
\end{array}
$$

Internal Factors Affecting Capital Structure

Business Model Characteristics

A company’s capital structure affects its capacity to repay debt. It is, nevertheless, worth noting that the risk inherent in a company’s business strategy can significantly impact its capital structure. The key factors that differ among business models include:

• Revenue, earnings, and cash flow sensitivity: Some companies have unpredictable revenues that impede their capacity to maintain debt in their capital structures. In contrast, others have relatively consistent revenue streams that enhance their ability to service debts. The ratio of a company’s fixed and variable costs will also affect how stable and predictable its earnings and cash flows are.
• Asset type: Assets can either be classified as tangible or intangible, fungible or non-fungible, and liquid or illiquid.
  1. Tangible assets are identifiable physical assets such as inventory. Intangible assets, on the other hand, do not exist in physical form, and include items such as patents and copyrights. Creditors of a corporation will demand substantial security, preferring tangible over intangible assets.
  2. Assets that may be exchanged for other assets are referred to as fungible assets, and they include items such as money. On the other hand, non-fungible assets are unique assets, such as works of art, that cannot be exchanged.
  3. Illiquid assets, such as machinery and equipment, are difficult to convert into cash at their market prices. On the other hand, liquid assets may quickly be turned into cash without losing value.
• Asset ownership: Businesses may choose to “outsource” the ownership of their assets to other parties to cut costs and risks related to owning and maintaining a sizable quantity of fixed assets. For instance, franchises such as KFC may choose to sell their franchises rather than own all of their physical locations.

Existing Leverage

Compared to underleveraged companies, those with greater debt-to-capital ratios have a higher risk of default and a lower capacity to pay a new debt.

Corporate Tax Rate

In many countries, interest expenses are tax deductible. Due to its tax savings, a company’s after-tax debt costs will be lower than the actual costs. The tax benefit of employing debt in a company’s capital structure increases with the marginal income tax rate.

Capital Structure Policies/Guidelines

Firm-specific policies have an impact on capital structures. These policies may specify permissible debt levels in the capital structure, such as a debt-to-capital ratio of no more than 50%. Further, regulators may assess the capital structures of other companies, such as banks. Capital structure policies or guidelines are important for companies that frequently borrow since too much leverage might raise the risks involved.

Third-party Debt Ratings

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

External Factors Affecting Capital Structure

Market Conditions/Business Cycle

Market variables such as interest rates and the state of the macroeconomic conditions significantly impact a firm’s capital structure. Companies take on less debt as a result of high-interest rates. Business cycles that gauge macroeconomic circumstances will have an impact on the capital structure of a company. Businesses often borrow more while the economy is expanding and less when contracting.

Regulatory Constraints

Governments or other authorities may have the power to control the capital structures of some firms, such as banking and utility companies. Regulators require banks to maintain specific levels of solvency or capital adequacy.

Industry/Peer Firm Leverage

The sector a firm is in heavily influences its capital structure. Similar capital structures are shared by companies in the same industry. For instance, technology companies will have a low proportion of physical assets such as real estate, machinery, and equipment.

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 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.