Assignment 1: LASA # 2—Capital Budgeting Techniques
cabo1789
m4_capital_structure.docxCapital Structure
The capital structure of an organization is the combination of sources of funds such as debt, preferred stock, and common stock. The amount of debt that a firm uses to finance its assets is called leverage. A firm that carries a large amount of debt in its capital structure is said to have high leverage. A firm that does not carry any debt is said to be unlevered.
Debt Vs. Equity Financing
It is less expensive to finance a business through borrowing than through equity because:
· Lenders expect a lower rate of return than shareholders. Debt financial securities present a lower risk than shares for finance providers because they have prior claims on annual income and liquidation. In addition security is provided and covenants are incorporated into bond contracts, which reduce the risk to bondholders.
· The debt interest can be offset against pretax profits before the calculation of the corporation tax bill thereby reducing the tax to be paid.
· Issuing and transaction costs associated with raising and servicing debt are generally less than for shares.
These are a few benefits of financing with debt. However, firms tend to avoid very high leverage levels because of the risk of financial distress. This risk arises as a result of requiring to pay interest, regardless of the cash flow of the business. If the firm goes through a recession, it may find it difficult to pay bondholders, bankers, and other creditors. Doing so would most likely result in bankruptcy.
Determinants of the Optimal Capital Structure
· The Tax Deductibility of Interest: Tends to increase the use of debt in the firm's capital structure.
· Financial Risk: The increased financial risk as a result of increased use of debt tends to moderate the use of debt in the firm's capital structure.
