Capital structure policy is a trade-off between risk and return:
· Using debt raises the risk borne by stock holders
· Using more debt generally leads to a higher expected rate on equity.
There are four primary factors influence capital structure decisions:
· Business risk, or the riskiness inherent in the firm's operations, if it uses no debt. The greater the firm's business risk, the lower its optimal debt ratio.
· The firm's tax position. A major reason for using debt is that interest is tax deductible, which lowers the effective cost of debt. However if most of a firm's income is already sheltered from taxes by depreciation tax shields, by interest on currently outstanding debt, or by tax loss carry forwards, its tax rate will already be low, so additional debt will not be as advantageous as it would be to a firm with a higher effective tax rate.
· Financial flexibility or the 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 is vital for long-run success. They also know that when money is tight in the economy, or... [continues]
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