The Target Capital buildings

Firms can choose anything mix of debt and equity they desire to finance their assets, branch to the willingness of investors to contribute such funds. And, as we shall see, there exist many distinct mixes of debt and equity, or capital structures - in some firms, such as Chrysler Corporation, debt accounts for more than 70 percent of the financing, while other firms, such as Microsoft, have small or no debt.

In the next few sections, we discuss factors that influence a firm's capital structure, and we conclude a firm should endeavor to decide what its optimal, or best, mix of financing should be. But, you will find that determining the exact optimal capital buildings is not a science, so after analyzing a amount of factors, a firm establishes a target capital buildings it believes is optimal, which is then used as a guide for raising funds in the future. This target might change over time as conditions vary, but at any given moment the firm's supervision has a exact capital buildings in mind, and individual financing decisions should be consistent with this target. If the actual proportion of debt is below the target level, new funds will probably be raised by issuing debt, whereas if the proportion of debt is above the target, stock will probably be sold to bring the firm back in line with the target debt/assets ratio.

Target

Capital buildings course involves a trade-off between risk and return. Using more debt raises the riskiness of the firm's wage stream, but a higher propor- tion of debt generally leads to a higher expected rate of return; and, we know that the higher risk connected with greater debt tends to lower the stock's price. At the same time, however, the higher expected rate of return makes the stock more thoughprovoking to investors, which, in turn, finally increases the stock's price. Therefore, the optimal capital buildings is the one that strikes a balance between risk and return to accomplish our extreme goal of maximizing the price of the stock.

Four former factors influence capital buildings decisions:

1. The first is the firm's firm risk, or the riskiness that would be inherent in the firm's operations if it used no debt. The greater the firm's firm risk, the lower the amount of debt that is optimal.

2. The second key factor is the firm's tax position. A major infer for using debt is that interest is tax deductible, which lowers the efficient cost of debt. However, if much of a firm's wage is already sheltered from taxes by accelerated depreciation or tax loss carryforwards, its tax rate will be low, and debt will not be as advantageous as it would be to a firm with a higher efficient tax rate.

3. The third foremost consideration is financial flexibility, or the quality to raise capital on inexpensive terms under adverse conditions. Corporate treasurers know that a steady contribute of capital is requisite for garage 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 regain funds from suppliers of capital. Thus, it might be advantageous to issue equity to enlarge the firm's capital base and financial stability.

4. The fourth debt-determining factor has to do with 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 endeavor to boost profits. This factor does not influence the optimal, or value- maximizing, capital structure, but it does influence the target capital buildings a firm undoubtedly establishes.

These four points largely decide the target capital structure, but, as we shall see, operating conditions can cause the actual capital buildings to vary from the target at any given time. For example, as discussed in the Managerial Perspective at the beginning of the chapter, the debt/assets ratio of Unisys clearly has been . Much higher than its target, and the firm has taken some requisite correc- tive actions in up-to-date years to improve its financial position.

The Target Capital buildings