Effects of Capital Structure Policy

When evaluating the capital structure of a company, an analyst must consider the following:

1. The capital structure of the company over time. The financial analyst can evaluate the company’s ability to handle its financial obligations, considering the industry the company operates.
2. The capital structure of the competitors that have similar business risks. Companies with similar business risks, such as pharmaceutical companies, need to be flexible financially to respond to competition.
3. Company-specific factors such as the quality of corporate governance may affect agency costs.

The common goal of capital structure decisions is to finance the company’s operations at the lowest cost of capital.

Question

Which of the following is a factor that an analyst is most likely to consider when evaluating a capital structure policy?

1. The capital structure of the competitors that have different business risks.
2. The capital structure of the company over time.
3. The extent to which a product is affected by market conditions.

Solution

The correct answer is B.

When evaluating a company’s capital structure policy, it is important to evaluate the capital structure over time and its target capital structure.

Reading 15: Capital Structure

LOS 15 (c) Explain factors an analyst should consider in evaluating the effect of capital structure policy on valuation.