Page 184 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

4. Industry Leverage Ratios: The Industry standards provide benchmark. Firm can use industry Notes
leverage ratio as standard for construction of capital structure. Because industry standard
may be appropriate to the firm. It does not mean that all firms in the industry are having
optimum capital structure. Put it simple, they may be using more leverage or less leverage,
but it suggests that whether the firm is out of line or not, if it is it should know the reasons
why and be satisfied with the reasons.
5. Seasonal Variations: Use of more or less financial leverage depends on the seasonal
variations of the business. Low degree of financial leverage (less debt) is preferable when
a firm’s business is seasonal in nature. Example, Businesses such as production and sale of
umbrellas, fans, air coolers., industries requires less debt capital in their capital structure.
Use of more debt may make the firm unable to pay interest obligations in lean years,
which would lead to financial distress. On the other hand, industries involved in business,
where there is no seasonality, like consumer non-durable products (food items, soaps, etc)
or with items in habitual use (cigarette) or all those products, which have an inelastic
demand are not likely to be subject to wide fluctuations in sales can use more debt in their
capital structure, since they are able to earn regular profit.
6. Degree of Competition: Competition in the industry also determines the capital structure.
When, there is no or less competition then, the firms can use less equity or more debt in
their capital structure, since they can sell more products at higher prices. Example, public
utility corporations like gas, electricity, etc. On the other hand, competitive firms have to
use more equity in their capital structure, because of competition; they may not be able to
sell more units and cannot earn more profits. Example, garment industry, home appliances
industry.
7. Industry Life Cycle: The Industry life cycle consists of introduction stage; growth stage;
maturity stage and declining stage. The industry in infancy should use less debt capital or
more equity capital in capital structure, since the profit earning capacity is less due to less
sales where as when a firm is in its growing stage (fast) and having more profits, it can go
for more debt or less equity that helps to maximise shareholder wealth.

8. Agency Costs: Agency costs arises when there is a conflict of interest among owners,
debenture holders and the management. Conflict may arise due to the transferring of
wealth to debt holders in their favour. The agency problem is handled through monitoring
and restrictive covenants, which involve costs that are called agency costs. The financing
strategy of a firm should seek to minimise the agency costs, by way of employing an
external agent who specialises in low-cost monitoring. Management should use debt
finance to the extent that it maximises the wealth of shareholders, not beyond that.
9. Company Characteristics: Characteristics like size and credit standing among other
companies (within or outside industry). Small firm’s ability to raise funds from outside is
limited when compared to large firms. Small firms have to depend on owners’ funds for
financing activities. In other words, investors perceive that investment in small firms is
more risky than the large firms. On the other hand, large firms are forced to make use of
different sources of funds, because no single source is sufficient to their needs.

When it comes to the credit rating characteristics a firm enjoying high credit rating may
get funds easily from the capital market, as compared to other firms, which are having
low credit rating. Because investors and creditors prefer to invest and grant loans to high
credit rating firms, since the risk is less.
10. Timing of Public Issue: Timing of public offer is also one of the most important factors
considered while planning the capital structure. Public offering should be made at a time
when, that state of the economy as well as capital market is ideal to provide the funds.

LOVELY PROFESSIONAL UNIVERSITY 179