Capital Structure: Determinants

Capital Structure decisions depend on its  Determinants. There are many determinants of capital structure, some of them are :-

Firm size: Larger  firms  are  likely to have  higher  debt  levels  to  maximize  the  tax  benefits from  debt. Large firms have a larger capacity for leverage due to lower bankruptcy risk and agency cost of debt with stable cash flows compared to smaller firms.

Tangibility: Firms with larger tangible assets have greater leverage capacity, which reduces the possibility of mispricing in the event of liquidation. Tangible assets, which can be used as collateral for debt, suffer a smaller loss of value when firms go into distress and reduce the scope of asset substitution effect.

Profitability: Profitable firms would employ more debt since expected bankruptcy costs are lower and expected tax shields are higher. Profitable firms carry a larger amount of debt due to the benefits of tax deductibility

Growth opportunities: Firms with growth opportunities may find it difficult and costly to rely on debt for financing as  the  degree  of risk  may  be  high  for  growth  oriented  investments. Firms with high growth rates tend to accept risky projects and try to increase the shareholders’ wealth.

Non – debt tax shields: It acts as an alternative to interest tax shields of debt. Firms could reduce tax payments by using more debt rather than equity in financing their investments.

Business  risk: Firms  with high  business  risk  are  likely  to face  higher  costs  of  bankruptcy  and  will  therefore  use less  debt.

Liquidity: A firm should   have high liquidity in order to meet high debt service obligation. The disciplining  benefit  of  debt  due  to  agency  problems  causes  cash-rich firms to  acquire  additional  debt so  that ,  after  meeting  the  debt  servicing obligation, managers have  little  free  cash  flows.

Firm age: Younger firms cannot afford debt as their bankruptcy costs are high, and their earnings are too low to utilize the benefit of interest tax shield. Hence, age and leverage are expected to be positively related.

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