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Capital Structure


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Capital Structure

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  2. 2. <ul><li>A way a corporation finances itself through some combination of equity and debt. </li></ul><ul><li>The capital structure should be designed with the aim of maximizing the market valuation of the firm in the long run. </li></ul>Capital Structure
  3. 3. Determinants of Capital Structure <ul><li>Type of asset financed </li></ul><ul><li>Ideally short term liabilities should be used to create short term assets and long term liabilities for long term assets. </li></ul><ul><li>Else an AL mismatch may take place which may introduce an element of risk. </li></ul>
  4. 4. Determinants of Capital Structure <ul><li>Nature of the Industry </li></ul><ul><li>A firm relies more on long term debt and equity if its capital intensity is high. </li></ul><ul><li>If the business is seasonal in nature, needs at seasonal peaks may be financed by short term debt. </li></ul><ul><li>Capital structure should be suitably designed keeping the nature of the industry. </li></ul>
  5. 5. Determinants of Capital Structure <ul><li>Degree of Competition </li></ul><ul><li>A business characterized by intense competition and low entry barriers faces greater risk of earnings fluctuations. Equity financing may be more appropriate here. </li></ul><ul><li>A business characterized by less competition and high entry barriers faces lower risk of earnings fluctuations. </li></ul>
  6. 6. Determinants of Capital Structure <ul><li>Obsolescence </li></ul><ul><li>Key factors that lead to Obsolescence need to be identified. </li></ul><ul><li>Obsolescence can occur in products, manufacturing processes, materials and even in marketing. </li></ul><ul><li>If chances of obsolescence are high, capital structure should be built conservatively. </li></ul>
  7. 7. Determinants of Capital Structure <ul><li>PLC </li></ul><ul><li>At the introduction stage, risks are high. Therefore, equity is the primary source of finance. Financial leverage may not be affordable. </li></ul><ul><li>Growth phase – Risks may decrease but huge investments may be needed which may require doses of debt plus periodic induction of equity. </li></ul><ul><li>In maturity, leverage is likely to decline as cash flows accelerate. </li></ul>
  8. 8. Determinants of Capital Structure <ul><li>Financial Policy </li></ul><ul><li>Capital structure to be designed keeping in mind the overall financial policy of the firm. </li></ul><ul><li>The management might have decided on </li></ul><ul><li>2.1 Debt : Equity ratio </li></ul><ul><li>2.2 Dividend Payout </li></ul><ul><li>2.3 Debt Service coverage </li></ul>
  9. 9. Determinants of Capital Structure <ul><li>Past and Present Capital Structure </li></ul><ul><li>Determined by past events. </li></ul><ul><li>Prior financing, investment, acquisitions, may create conditions which may be difficult to change in the short run. </li></ul><ul><li>However medium to long term decisions to alter capital structure may be effected by issuing and retiring debt, issuing equity, equity buy backs, altering dividend policies etc. </li></ul>
  10. 10. Determinants of Capital Structure <ul><li>Corporate Control </li></ul><ul><li>Firms vulnerable to takeover are averse to further issuance of equity as it can result in the dilution of the ownership stake. </li></ul><ul><li>Such firms place more reliance on debt. </li></ul><ul><li>Firms with strong management (having controlling stake) are unlikely to have reservations over further issue of equity. </li></ul>
  11. 11. Determinants of Capital Structure <ul><li>Credit Rating </li></ul><ul><li>Market assigns a great deal of weightage to the credit rating of a firm. Hence obtaining a good rating has become imperative. </li></ul><ul><li>Market reacts negatively to any downgrading in the rating. </li></ul><ul><li>This may result in a denial of access to capital. </li></ul>
  12. 12. <ul><li>Thank You </li></ul>