Capital structure planning importance, determinants

Importance of capital structure planning

1. Minimises the cost of capital, which raises the value of the firm.
2. Maximises EPS and shareholders' wealth by using leverage properly.
3. Ensures liquidity and solvency, so interest and loans are paid on time.
4. Keeps control of the owners.
5. Gives flexibility for future financing and growth.
6. Reduces financial risk and helps the firm to survive in bad times.
7. Improves the credit rating and the confidence of investors.

Determinants (in brief)

1. Cash flowability: the ability to generate enough cash to pay interest and repay debt. Stable, high cash flow allows more debt (measured by interest coverage and debt service coverage ratio).
2. Leverage / trading on equity: if the return on investment is higher than the interest rate, more debt increases EPS; if lower, it reduces it.
3. Cost of capital: debt is cheaper because interest is tax deductible; the structure with the lowest weighted average cost of capital is preferred.
4. Control: issuing new equity dilutes the control of existing owners, so they may prefer debt.
5. Flexibility: the firm should keep unused borrowing capacity for future needs.
6. Marketability and timing: condition of the capital market, investor demand, and the best time for share or bond issue.
7. Size and stage of the firm: large, established firms have easier access to debt and equity.
8. Nature of the business: stable-demand projects (e.g. hydropower with PPA) can carry more debt than cyclical businesses.
9. Legal and tax factors: limits on debt-equity ratio by regulators, tax rate, covenants of lenders.
10. Risk (business and financial): high business risk needs less debt.