CHOOSING THE RIGHT CAPITAL STRUCTURE AND TAXATION

Capital structure determines the way in which a business can finance its assets.

The optimal capital structure is the mix of debt and equity that maximizes the value of the firm by maximizing return on capital.

The important considerations that business firms must take into account when planning out their capital structure are :

1) Cost of Capital

2) Tax

3) Signaling consideration

4) Bankruptcy Consideration

Cost of Capital:   The cost of capital must be majorly taken into consideration by firms in order to choose the right capital structure. In order to have a valuable investment, the expected return on capital must be greater than the cost of capital.

We need to calculate both the cost of debt and cost of equity to determine the company’s cost of capital since the company’s finances include both debt and equity.  

The cost of issuing debt is less than that of equity because of tax advantages as interest payments can be deducted from taxable income. However, too much debt can increase the default risk, and the cost of issuing debt will increase at some point. Therefore firm must identify the “optimal mix” of financing, so as to maximize the firm’s value. 

Tax Consideration:

Tax considerations impact the way a company determines its capital structure and deals with its costs of capital.

The tax-deductibility of interest makes debt financing worthwhile; that is, there will be a decrease in the cost of capital as the proportion of debt in the capital structure increases. The optimal structure then would include no equity.

We would think that corporate tax rates demand an increase in usage of debt to finance capital as compared to equity since dividend payments are not tax-deductible but interest payments are. However, there are many things that come under tax applicability, like firm location and size, this is a generality at best.

Different tax considerations impact the costs of debt and equity, and how they are used, relative to each other, in financing the capital of a company.

Signaling consideration: Signaling is defined as conveying nonpublic information through public action. It is a technique used in making decisions related to capital structure.

Signaling can change the way investors think about a firm. The information that is made public about the firm can alter the way investors view a firm I.e how much value they assign.

We can say, issuing new equity can be seen as a bad signal for the health of a firm and can decrease current share value. The issuance of equity can have benefits, as investors might be taking part in potential earnings growth however a company will usually issue debt over equity so as to avoid sending a negative signal.

Bankruptcy considerations: Bankruptcy occurs when a firm is unable to repay the debts owed to creditors and is working towards regaining solvency.

The risk of a company’s bankruptcy can influence the company’s cost of capital.

A debtor declares bankruptcy to obtain relief from debt. This is achieved either through a discharge of the debt through a restructuring of the debt.

When liquidation occurs one must remember that bondholders and other lenders are paid back first before equity holders. Usually, there is little to no capital left over for common shareholders.

Conclusion: The firms must take into account these considerations before they plan their capital structure so as to choose the right capital structure in order to maximize overall value and get the best returns.