The Target Capital Structure

The Target Capital Structure
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11/6/2005
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The Target Capital Structure
By Analia Jones
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Firms can choose whatever mix of debt and equity they desire to finance their assets,
subject to the willingness of investors to provide such funds. And, as we shall see, there
exist many different mixes of debt and equity, or capital structures - in some firms, such as
Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other
firms, such as Microsoft, have little or no debt.
In the next few sections, we discuss factors that affect a firm's capital structure, and we
conclude a firm should attempt to determine what its optimal, or best, mix of financing
should be. But, you will find that determining the exact optimal capital structure is not a
science, so after analyzing a number of factors, a firm establishes a target capital structure it
believes is optimal, which is then used as a guide for raising funds in the future. This target
might change over time as conditions vary, but at any given moment the firm's management
has a specific capital structure in mind, and individual financing decisions should be
consistent with this target. If the actual proportion of debt is below the target level, new
funds will probably be raised by issuing debt, whereas if the proportion of debt is above the
target, stock will probably be sold to bring the firm back in line with the target debt/assets
ratio.
Capital structure policy involves a trade-off between risk and return. Using more debt raises
the riskiness of the firm's earnings stream, but a higher propor- tion of debt generally leads
to a higher expected rate of return; and, we know that the higher risk associated with
greater debt tends to lower the stock's price. At the same time, however, the higher
expected rate of return makes the stock more attractive to investors, which, in turn,
ultimately increases the stock's price. Therefore, the optimal capital structure is the one that
strikes a balance between risk and return to achieve our ultimate goal of maximizing the
price of the stock.
Four primary factors influence capital structure decisions:
1. The first is the firm's business risk, or the riskiness that would be inherent in the firm's
operations if it used no debt. The greater the firm's business risk, the lower the amount of
debt that is optimal.
2. The second key factor is the firm's tax position. A major reason for using debt is that
interest is tax deductible, which lowers the effective cost of debt. However, if much of a
firm's income is already sheltered from taxes by accelerated depreciation or tax loss
carryforwards, its tax rate will be low, and debt will not be as advantageous as it would be to
a firm with a higher effective tax rate.
3. The third important consideration is financial flexibility, or the ability to raise capital on

The Target Capital Structure
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reasonable terms under adverse conditions. Corporate treasurers know that a steady supply
of capital is necessary for stable operations, which, in turn, are vital for long-run success.
They also know that when money is tight in the economy, or when a firm is experiencing
operating difficulties, a strong balance sheet is needed to obtain funds from suppliers of
capital. Thus, it might be advantageous to issue equity to strengthen the firm's capital base
and financial stability.
4. The fourth debt-determining factor has to do with managerial attitude (conservatism or
aggressiveness) with regard to borrowing. Some managers are more aggressive than others,
hence some firms are more inclined to use debt in an effort to boost profits. This factor does
not affect the optimal, or value- maximizing, capital structure, but it does influence the
target capital structure a firm actually establishes.
These four points largely determine the target capital structure, but, as we shall see,
operating conditions can cause the actual capital structure to vary from the target at any
given time. For example, as discussed in the Managerial Perspective at the beginning of the
chapter, the debt/assets ratio of Unisys clearly has been . much higher than its target, and
the company has taken some significant correc- tive actions in recent years to improve its
financial position.
Analia Jones is a Business Developer Manager of http://www.my-mortgege-loans.co.uk
http://www.my-mortgage-loans.com
http://www.2-structured-settlement.com
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Article Submitted On: July 24, 2005