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Because of the difficulty in determining a firm's optimal or target capital structure, financial managers depend on both quantitative analysis and judgment in practice. Some things that are considered are:
Profitability and Stability
Can you think of any others? What factors might be important with respect to the issues listed above.
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The solution discusses the factors that might be important in determining a firm's optimal or target capital structure.
Capital structure is a mix of debt and equity. Debt has tax benefits, so firms should use some debt. However financial distress and agency costs limit debt usage. Distress costs are higher for firms with intangible assets. Because of the presence of asymmetric information, firms will follow pecking order in the capital structure. (Pecking order: Internally generated funds are the most preferred, followed by new debt, and debt-equity hybrids. Finally, new equity is at the least preferred source.) Because of asymmetric information, firms should also maintain reserve for borrowing.
The optimal, or target capital structure is the structure with the lowest possible WACC. The Interest Tax Shield (deductibility of interest as expense ) is critical here, because it effectively lowers the cost of debt. Therefore for many firms, the use of financial leverage (debt financing) can lower WACC and increase profitability. However there is a warning: choice between debt & equity can not be based on interest rates, etc. alone. Risk must be considered as well. The systematic risk (which cannot be diversified ) consists of two factors which must be considered: Business risk which is the risk inherent in firm's operations and Financial risk which is the risk inherent in using debt financing. We must remember that debt is a magnifier: it can magnify returns if returns > cost of debt, but it can also magnify losses, or returns < cost of debt.
Optimal capital structure is achieved by finding the point at which the tax benefit of an extra dollar of debt = potential ...
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