Question

What important factors, in addition to quantitative factors, should a firm consider when it is making a capital structure decision? How do these factors play in the decision? Be sure to support your ideas with examples from your own experience or other firms or sources.

Answer 1

In deciding the capita structure decision ,the important qualitative factor to be considered are

1. Control : While taking the decision on capital structure, the firm may have the desire to retain the control over the company. They may have fear of losing control over the company as there would be interference in the management of the company. In order to prevent this, the company may decide to go for preference or debt instruments.

Example: Liverpool Inc is a closelyheld company owned by Rob and Mob. The want to raise additional capital almost equal to their current equity. But, they do not intend to allow some other person to interfere in their working So even though debt is available at a higher cost they choose the debt option to prevent liquidation in equity.

2.Size of the company: The size of a company influences the availability of funds from different sources. A small company may find it difficult to raise long-term loans. If it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loans agreements of small companies make their capital structure quite inflexible.So due to the size of the being a constraint, they have to opt for another source of finance.

Example : Liverpool Inc is a recently incorporated company they want to raise loan for their new project, they apply to to the banks for loans but as the company is new the banks offer them loan at a higher interest rate. As the cost of equity is lesser than debt they opt for equity. Thus size being a constraint.

3. Management Style: Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).

Example : The management of Liverpool Inc is very conservative,they fear that by opting for debt they would be under pressure to pay the interest so they decide not to take debt and raise more equity.