Guidelines for capital structure decisions
The capital structure decision involves taking
into consideration several factors including income, risk,
flexibility, control, timing etc. The following guidelines
could help managers in capital structure decisions: -
Interest on debt is a tax-deductible expense
and hence reduces the tax burden. The advantage of a tax
shelter motivates the company to raise more loans from the
market. The market value of the firm would increase with
the decreased tax burden.
Utilising the maximum loan capacity to reduce
tax expenses is not always the right decision for a company.
The company should have the flexibility to borrow when the
situation changes, due to changes in government policies,
disruption in supplies, labour unrest etc. Unused debt capacity
at such a time could enhance this flexibility.
Managers need to ensure that the total risk
exposure of a company is within controllable limits. Business
risk is based on the proportion of fixed costs and variability
in demand, price and input prices. Financial risks, which
indicate the financial leverage of the company, arise from
the debt portion of its capital structure. A company cannot
keep both the risks at a very high level.
If more equity is issued to the public, control
will get diluted for the promoters, whereas with debt issue
it will be retained with the company.
Financial policy makers are from the capital
market whereas corporate policy makers are from the product
market. To integrate these two policies the chief executive
of a company should:
-
Thoroughly check the factors underlying
the financial policy
-
Ensure that the financial policy will
support corporate strategy
-
Increase the involvement of operating
managers in determining financial policy
-
Restrict financial policy from becoming
corporate goal
Although it is difficult to predict the proper
timing for raising capital in the market, the following
thumb rules may be helpful in improving a company’s
performance in terms of timing into the market:
-
Take the best possible opportunity available
at present in the market rather than waiting for a more
advantageous time in the future. It may or may not materialise.
-
Follow the trend in the financial market
-
Wait till the market captures the full
potential of the company and reflects it in the share
price
Debt can be obtained easily if backed by tangible
assets as security and accompanied by good credit rating.
Companies can take advantage of the same.
Subject to the guidelines issued by the SEBI
from time to time, a company can issue different kinds of
financial instruments for raising resources from the market.
However, these should be attractive and easily understandable
by investors.
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