What is capital structure?
The combination of Debt and Equity used to finance a firm is called Capital Structure.
Target capital structure is the mix of debt, preferred stock, and common equity with which the firm plans to finance its investments.
Factors affecting the target Capital Structure
a. Business Risk
b. Firm’s Tax position
c. Financial Flexibility
d. Managerial Attitude
Business risk is affected primarily by
a. Uncertainty about demand (sales).
b. Uncertainty about output prices.
c. Uncertainty about costs.
d. Product, other types of liability.
e. Operating leverage.
What is Leverage?
Leverage is the degree to which an investor or business is utilizing borrowed money.
Companies that are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also be unable to find new lenders in the future.
Leverage is not always bad, however; it can increase the shareholders‘ return on investment and often there are tax advantages associated with borrowing
Leverage are in two types:
a. Operating Leverage and
b. Financial Leverage.
These are those costs that are not dependent on the quantity of product. In other words, these costs stay the same whether you produce one piece of shirt or many pieces of shirts in your garments.
Example: Rent of a garments factory. Whether you are producing anything or not, you still have to pay the rent every month so for all intents and purposes your rent is a fixed cost.
Examples of Fixed Costs: salaries, rent, advertising, insurance and office supplies
Variable costs are costs that are dependent on the quantity of products.
Example: Raw materials – Cloths. If 5 feet cloths need to make 01 Shirt, 10 feet cloths will be needed to make 02 shirts.
Examples of Variable costs: material, labor, utilities, and delivery costs, hourly wages