Answer to Question #6768 in Economics of Enterprise for LaMarcus Streeter

Question

Analyze the approaches to capital structure decisions and determine which theory is the most applicable across the widest number of scenarios. Explain your rationale.

Answer 1

Capital structure is a mix of a company's long-term debt, specific short-term debt, common equity and preferred equity.
The capital structure is also how a firm finances its overall operations and
growth by using different sources of funds.
A company's proportion of short and long-term debt is considered when analyzing the capital structure. When people
refer to capital structure they are most likely referring to a firm's
debt-to-equity ratio, which gives insight of how risky a company is. Normally a
company more heavily financed by debt poses greater risk, as this firm is
relatively highly levered. Also, we should state that the primary factors that
influence a company's capital-structure decision are:
1.Business risk
2.Company's tax exposure
3.Financial flexibility
4.Management style
5.Growth rate
6.Market Conditions
The target (optimal) capital structure is simply defined as the mix of debt, preferred stock and common equity that will
optimize the company's stock price. As a company raises new capital it will
focus on maintaining this target (optimal) capital structure. It is also
important to note that while the target structure is the capital structure that
will optimize the company's stock price, it is also the capital structure that
minimizes the company's weighted-average cost of capital (WACC).