The Target Capital Structure

To maximize the price of the stock one has to strike a balance between risk and return. The target capital structure aims at this goal.

One has to understand the factors that influence  capital structure decisions. To name few

  • Firms business risk

  • Firms Tax Position

  • Financial flexibility

  • Debt Determining factor

If the firm uses debt the  business risk is inherent in the firms operations.  The greater the firms business risk, the lower the amount of debt that is optimal.

 The interest on debt component is tax deductible and effective cost of debt is lowered.  However, if  firms income is already sheltered from taxes by accelerated depreciation or tax loss carry forwards, its tax rate will be low, and debt will not be as advantageous as it would be to a firm with a higher effective tax rate.

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, in turn, are vital for long-run success. They also know that when money is tight in the economy, or when a firm is experiencing operating difficulties, a strong balance sheet is needed to obtain funds from suppliers of capital. Thus, it might be advantageous to issue equity to strengthen the firms capital base and financial stability.
 

Managerial attitude (conservatism or aggressiveness) with regard to borrowing. Some managers are more aggressive than others, hence some firms are more inclined to use debt in an effort to boost profits. This factor does not affect the optimal, or value- maximizing, capital structure, but it does influence the target capital structure a firm actually establishes.
 

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