Factors Affecting Capital Structure Decisions | CFA Level I Corporate Issuers

In this lesson, we’ll explore the factors that influence capital structure decisions, such as debt ratings, business characteristics, external factors, agency costs, and asymmetric information costs.

Debt Ratings and Their Impact on Capital Structure

As we learned in Fixed Income, credit rating agencies assess the credit quality of issuers and their debt issues, assigning ratings based on default risk. Debt ratings are crucial for managers because they directly affect the company’s cost of capital.

• Investment-grade bonds: Rated BBB- or higher
• Non-investment grade bonds: Rated BB+ or lower, often called high-yield bonds or junk bonds
• Defaulted bonds: Rated D by Standard & Poor’s and Fitch, or C by Moody’s

Managers aim to maintain or improve their company’s debt rating to avoid increased costs of capital due to downgrades. Key accounting ratios, such as coverage ratios and leverage ratios, are important for evaluating creditworthiness.

Business Characteristics Impacting Capital Structure

Various business model characteristics can influence capital structure decisions:

• Revenue and cash flow stability: Companies with predictable revenues and cash flows can support more debt.
• Fixed costs: Companies with high fixed costs can reduce them by leasing assets or outsourcing work functions, leading to an “asset-light” approach that allows for more debt.
• Collateral types: Creditors prefer tangible, liquid, and fungible assets, which can lower a company’s cost of debt and increase its capacity to take on debt.

External Factors Affecting Capital Structure

Market conditions, regulations, and industry norms can also impact a firm’s financing decisions:

• Market conditions: Managers may issue stocks when the market price is high or repurchase stocks when undervalued. They may also issue debt when market interest rates are low.
• Regulatory constraints: Some industries, such as financial institutions and public utilities, must meet specific capital adequacy standards.
• Industry norms: Company management may consider industry norms when making capital structure decisions.

Agency Costs and Capital Structure

Agency costs arise from conflicts of interest between a firm’s management and shareholders. They have three components:

1. Monitoring costs: Expenses associated with supervising management, such as annual reports and board of director fees.
2. Bonding costs: Costs taken on by management to assure shareholders of their commitment to shareholder interests.
3. Residual losses: Occur despite adequate monitoring and bonding provisions.

According to agency theory, issuing debt rather than equity can reduce agency costs of equity by forcing managers to be more disciplined with cash flow usage.

Costs of Asymmetric Information in Capital Structure

Asymmetric information costs result from managers having more knowledge about a company’s prospects than shareholders or creditors. These costs lead to higher required returns on debt and equity capital.

Shareholders and creditors, aware that management may have more information, try to infer “signals” from management actions. Taking on debt financing shows commitment to meeting future cash flow obligations, while issuing equity may signal that managers believe the firm’s stock is overvalued.

The signaling model suggests a hierarchy for financing new investments, known as the pecking order theory:

1. Internally generated equity (retained earnings)
2. Debt
3. Public equity offerings (least preferred)

According to this theory, raising additional capital through public equity issuance may be seen as a sign of desperation, signaling the company’s lack of financing options and potentially negative future prospects.

Competing Stakeholder Interests in Capital Structure Decisions

In our next lesson, we’ll delve into competing stakeholder interests in capital structure decisions. See you there!

In summary, various factors impact capital structure decisions, including debt ratings, business characteristics, external factors, agency costs, and costs of asymmetric information. Understanding these factors can help managers make informed decisions that maximize shareholder wealth and company growth.