The Target Capital Structure
To maximize the price of the stock one has to
strike a balance between risk and return. The target capital structure aims at
this goal.
One has to understand the factors that
influence capital structure decisions. To name few
Firms business risk
Firms Tax Position
Financial flexibility
Debt Determining factor
If the firm uses debt the
business risk is
inherent in the firms operations. The greater the firms
business risk, the lower the amount of debt that is optimal.
The interest on debt component is tax deductible and effective cost of
debt is lowered. However, if firms income is already sheltered from taxes by
accelerated depreciation or tax loss carry forwards, 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.
Ability to raise capital
on 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 firms capital base and financial
stability.
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.
