Question

3. (a) Under what conditions do you think that the finance manager does not have to think about capital structure issue? (1 Mark) (b) Discuss the various factors affecting the capital structure decisions giving appropriate examples. (1 Mark)

Answer 1

a) A finance manager does not have to think about Capital structure issue for the following situation:

If a firm is cash rich and if it does not have the potential to expand the present line of business in any untapped area, he does not have to think about capital structure. Capital structure is need to be right to maximize shareholders return. As the firm is already cash rich, it's shareholder must be getting good return and as it does not have option to expand, it need not to think about capital structure.

If a firm is about to liquidate or it's product is dying out in the market and no investor want to infuse cash in the company, then he does not need to think about the capital structure, as it company will be liquidate unless some fortunate cash investment comes in.

b) There are various decision which affects capital structure decision which are given below:

i) If the debt -equity ratio is too high i.e. more than 1, then chances of default is also higher and cost of equity is also higher. In this case debt need to be reduced.

ii) In the same way, if a firm has much more weight in equity, then it need to bring back the debt equity ratio where shareholders return will be maximum.

iii) If the cost of equity is too high, then debt should be improved and reduce equity and vice versa.

iv) Tax shield need to be consider when considering the cost of debt and determining the capital structure. If a firm has 15% cost of equity with weight of 50% and 50% weight in debt with cost of 12% and tax rate is 40%, the effective cost of debt is 12%*(1-40%)=7.2%. As the cost of debt is much lower than cost of debt, the form should increase weight of debt.