This is “Capital Structure”, section 15.3 from the book Finance for Managers (v. 0.1).
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The mix of debt and equity that a firm uses to finance its operations is called its capital structureThe mix of debt and equity that a firm uses to finance its operations.. The more debt employed, the more leverage a firm will have, and the larger the potential variation in earnings for shareholders. But there are other factors involved which can also affect what is the optimal capital structure for a firm.
The largest factor will be the firm’s confidence in being able to make timely debt payments. Different businesses lend themselves to very different capital structures. A company with a steady customer base, large amounts of fixed capital or other good collateral, and insensitivity to the business cycle and other shocks to revenue all will point to a company having the capacity for more debt. The paragon of such a company would be a utility company: revenues will be very steady, since even financially strapped customers don’t want to freeze in the winter. Companies with uncertain, highly-variable revenues or a lack of good collateral will not be able to raise as much debt financing.
Another key factor is that interest paid on debt is tax deductible in most countries. If all else were equal, companies would probably choose to carry more debt vs. less debt because of the tax benefits.
Too much debt, however, and the costs of additional debt can outweigh the tax benefits. As debt level increases, so does the cost of debt that investors will charge in higher expected yields. The added risk is also a factor for equity investors: leverage multiplies the systematic risk of a company, causing investors to demand a higher return on equity. Potential financial distress can also cause a loss of customers (who wants to buy a car with a warranty if the company won’t be around to back it up) or suppliers (will the company be able to pay for the raw materials received?).
In theory, every project should be evaluated with a WACC using a capital structure utilizing costs of capital that reflect the risks of the project considered. Likewise, the capital structure (that is, weights) utilized in the calculation should ideally reflect the optimal mix for the marginal capital required for the project. In reality, most firms determine their target capital structure based on the overall nature of the firm’s operations, and only consider the effects of specific projects if they a relatively larger in scale (for example, if a large capital purchase would provide collateral that would facilitate more debt).