Question

Important factors to Consider in Making Capital Structure Decisions Concern Factor Revenue stability Business risk Cash flow Agency costs Contractual obligations Management preferences Description Firms that have stable and predictable revenues can more safely undertake highly leveraged capital structures than can firms with yol atile patterns of sales revenue. Firms with growing sales tend to be fit from added debt; they can reap the positive benefits of financial leverage, which magnifies the effect of these increases. When considering a new capital structure, the firm must focus on its ability to generate the cash flows necessary to meet obligations. Cash forecasts reflecting an ability to service debts (and preferred stock) must support any shift in capital structure. A firm may be contractually constrained with respect to the type of funds that it can raise. For example, a firm might be prohibited from selling additional debt except when the claims of holders of such debt are made subordinate to the existing debt. Contractual constraints on the sale of additional stock, as well as on the ability to distribute divi- dends on stock, might also exist. Occasionally, a firm will impose an internal constraint on the use of debt to limit its risk exposure to a level deemed acceptable to man. agement. In other words, because of risk aversion, the firm's manage ment constrains the firm's capital structure at a level that may or may not be the true optimum. A management group concerned about control may prefer to issue debt rather than (voting) common stock. Under favorable market conditions, a firm that wanted to sell equity could make a preemptive offering or issue onvoting shares, allowing each shareholder to maintain proportionate ownership. Generally, only in closely held firms or firms threatened by takeover does control become a major concern in the capital structure decision. The firm's ability to raise funds quickly and at favorable rates depends on the external risk assessments of lenders and bond raters. The firm must consider the impact of capital structure decisions both on share value and on published financial statements from which lenders and raters assess the firm's risk. At times when interest rates are low, debt financing might be more attractive; when interest rates are high, the sale of stock may be more appealing. Sometimes both debt and equity capital become unavail. able at reasonable terms. General economic conditions-especially those of the capital market-can thus significantly affect capital Control Asymmetric information External risk assessment Timing structure decisions. Since there is no cut-and-dried way to calculate the optimal capital structure, managers must take a number of items into account when trying to decide what capital structure would be best for their firm. A list of these items is given in Table 13.16 on page 590 of your textbook. Which of these items do you think are the most important when deciding the appropriate mix of debt and equity?

Answer 1

The most important factors in deciding the mix of debt and equity in a firm's capital structure are business risk, cash flow, and external risk assessment. These factors help determine the firm's capacity for debt, its ability to service that debt, and how the external market views the firm's financial health.

Step-by-step explanation:

When deciding the appropriate mix of debt and equity in a firm's capital structure, several factors must be considered. Among these, three stand out as particularly important: business risk, cash flow, and external risk assessment. Business risk refers to the stability of the company's revenues and the predictability of its sales, which can dictate the level of leverage a firm can safely undertake. Cash flow is crucial as it determines a firm's ability to service its debt and is a direct indicator of financial health. Finally, external risk assessment is vital because it influences a firm's ability to raise funds at favorable rates and impacts the perceptions of lenders and bond raters, which can affect the cost of capital.

Understanding the trade-offs between the control provided by debt financing and the shared ownership when issuing stock is fundamental to capital structure decisions. Debt financing, while obligating the firm to interest payments, retains the control within the existing management, not subjecting operations to shareholder decisions. Conversely, issuing stock dilutes ownership and subjects the firm to the demands of shareholders and a board of directors but does not add to financial obligations like scheduled interest payments in stressed financial periods.