Factors Influencing Capital Structure Decisions

Deciding the right mix of equity and debt is one of the more challenging decisions a firm's finance function makes, and several factors are weighed together before a workable capital structure is settled on.

Cost of capital is a starting point: debt is often a cheaper source of long-term funds than equity, because interest is a fixed, tax-deductible charge, whereas dividend to shareholders is not; a firm therefore tries to use a reasonable proportion of debt to keep its overall cost of capital down, without overusing it.

Risk is the natural counterweight to cost. Debt carries a fixed obligation to pay interest and repay principal regardless of whether the firm earns a profit, so a capital structure loaded too heavily with borrowed funds raises financial risk and, in a bad year, can threaten the very survival of the business. Firms with steady, predictable earnings can safely carry more debt than firms whose income fluctuates sharply from year to year.

Control is another consideration: raising fresh equity by issuing more shares can dilute the existing owners' voting control over the company, so promoters who wish to retain control sometimes prefer debt or preference capital, which do not carry ordinary voting rights, over issuing more equity shares.

Flexibility and the firm's ability to generate steady cash flow to service fixed interest and repayment commitments also matter, along with the nature and size of the business, general capital-market conditions (whether investors are currently willing to subscribe to new share issues), government regulations affecting the issue of shares and debentures, and tax considerations, since interest paid on debt reduces taxable profit while dividend does not. …