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Practical Considerations Influencing Capital Structure Essay

Making the right choice for an appropriate capital structure and an effective dividend policy is any firm’s major concern. This is because the decision not only affects the maximization of returns to the various constituents of an organization, but also contributes a lot to the organization’s competitive advantage. For this to be accomplished, firms, through the management put into perspective a number of practical aspects. An appropriate capital structure and dividend policy choice enables firms to maximize on their resources while enhancing the firm value.

Practical Considerations Influencing the Choice for a Firm’s Dividend Policy Shareholder Preferences Shareholder preferences play an immense role in influencing the decision for the dividend policy to adopt. As the firm owners, shareholders have expectations which they expect the management and the firm to meet. For instance, some expect to receive maximum dividends in terms of cash while others prefer an appreciation of their share value as a benefit to capital gains (Robert & David, 2009).

Such are investors belong to the maximum tax bracket since they often are subjected to less tax payments on capital gains. Shareholders differ and they vary from rich investors, small holder investors, institutional investors and even the retired or elderly groups.

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Closely-held companies are usually characterized by a low number of shareholders who either belong to similar group or are familiar with each other. In this regard, it is rather easier for firms to choose a dividend policy since the directors are conversant with the expectation of such shareholders (DeAngelo, et al.

2000). For instance, most could be wealthy shareholders who have more preference for capital rather than cash dividends. In the context of widely-held companies, the shareholder number is usually very high and is characterized by varying preferences for capital and dividend gains. This makes it difficult for the directors to choose a dividend policy that equally suits the needs for all. In such occasions the directors determine the group having the most number of shares and choose a policy that will satisfy their requirements.

Legal Requirements Payment of dividends is usually associated with certain constraints and these have to be taken note of before deciding on a dividend policy. For instance, the determination of the dividend policy ought to be within the framework of the statutory requirements. This is because in every country, there are particular restrictions governing the payment of dividends for the interest of the public (Frank & Goyal, 2004). In India for instance, the Companies Act stipulate that dividends can only be paid in cash while Sec.

205 of the same restricts companies to payment of dividends from the current profits only after assigning reserves for the depreciation of fixed assets (Holder, et al. 1998). The same applies to profits accumulated from the past, in that dividends are decided upon once reservations for depreciation have been made. Indian firms are also restricted to pay dividend from capital in a bid to ensure that the security available to creditors remain high. Statutory regulations thus have a greater impact on the dividend policy decision. Liquidity

Liquidity of funds plays an immense role in the decisions regarding the dividend policy. For instance, when the firm has substantial amounts of liquid resources, it is in a better position to pay higher dividends. Extensive expansion programmes following high profits impacts on the dividend policy decision since firms are restricted by insufficient liquidity (Allen & Michaely, 1995,). This issue mostly affects those companies embarking upon extensive expansion plans, those planning to redeem their debentures in a short while or the newly established firms.

On the other hand, a mature firm can be able to pay liberal dividends since they have substantial liquid assets as well as minimal profitable invest opportunities that can restrict their decisions such a policy. Directors take note of the liquidity of the firm before making a dividend policy decision. Financial Requirements When deciding on a firm’s dividend policy, directors consider the specific purpose as to why the company requires funding. This is done in line with the firm’s growth and expansion objective.

In most cases, shareholders prefer to obtain the maximum benefit in terms of high dividends while others; parties associated with the firm including the society, creditors, employees and customers mostly hold conflicting views in that the firm should retain part of its earnings (Brealey & Myers, 2000). It is essential that a firm doeas not pay dividends but rather retains a significant portion of its earnings in order to establish a strong financial stand.

Contingencies and diversification needs also influence the decision of firms including those performing well financially to retain an amount of their earnings by declaring lower dividends. Ideally, the circumstances lead the board of directors to a dividend policy that is not focused on 100 percent retention or a 100 percent pay out ratio (Robert & David, 2009,). For instance, the board of directors puts into consideration the availability of profitable investment ventures, which would lead to a situation where the cost of capital is much lower than the rate of returns or else above the expectations of the shareholders.

However, it is important to take note of the fact that when the firm does not have many profitable investment opportunities, the cost of capital is usually higher than the rate of return an hence it is imperative for the board of directors to consider issuing maximum dividends to enable shareholders, who have opportunities to alternative investment opportunities in other companies to generate more revenues. Thus, firms should consider how the rate of earnings in the long-term exceeds the demand for investments. Creditor Restrictions

In the event that the company obtains a loan from external sources, it is common for creditors to establish some restrictions on the firm level to ensure that their interests are emphasized. In this regard, creditors may fix restrictions that that prohibits the firm form paying dividends until a particular time when the firm attains a certain level of earnings (DeAngelo, et al. 2000). Alternatively, firms could also be restricted on the percentage of dividends they pay and this affects the decision on dividends.

Moreover, the creditors could regulate the earning retention ratio by quoting a mandatory portion of net earnings to be retained. Directors have thus to put into consideration the stipulations as a basis for any dividend policy to avoid penalties in regards to the whole capital amount. The Financial Position of a Firm The financial status of a firm has a great impact on the decision for a dividend policy. The more established and mature is a firm, the more access it has to external funding sources and the more retained earnings it is likely to have.

The firm is thus able to follow a liberal dividend policy. On the other hand, the growing firm may not have substantial earnings to retain and its access to external funding sources is limited. Whether a firm requires finances in the foreseeable future will affect its choice for a divided policy (Hines, 1996). The long-term growth forecast of the company is used to evaluate the financial needs of a firm and consequently the pay out ratio. Companies which have a high debt-equity ratio usually face the challenge of paying high interest charges and hence are very sensitive to changes in ratings.

In this regard, such firms strengthen their equity base by through retention of earnings. Accessing of a Firm to the Capital Markets The ease or difficulty of a firm in accessing the capital markets has a great implication on how the directors choose a divided policy. It is easier for a firm with more access to the capital markets to decide to adopt a liberal dividend policy (Prasad, et al. 2001). The mature and large sized firms as well as those firms which are financially strong are in a better position to benefit from the opportunities of such access.

It is usually hard for firms with minimal access to the capital market to externally raise funds and hence divided decisions are based on retention of earnings (Prasad, et al. 2001). These decisions also affect how funds for expansion plans are raised. Additionally, firms are usually required to pay minimum dividends for quite a number of years before they can access external financing from external financing institutions. This has a great impact on the dividend policy choice since the financial institutions, being established buyers of corporate securities do improve the image or prestige of a firm’s security.

Growth Opportunities Low pay out ratio alongside a high retention policy is common when there are many profitable investment ventures. This is more prevalent with the growing firms whose major aim is to get established. The reason for this is because the firm usually has difficulties in gain external access to funds from financing institutions for its growth objectives (Hines, 1996). Firms only choose a low pay out and high retention when there is availability of profitable investment ventures.

Incase the policy is pursued when there are no opportunities, the firm lacks the capacity or opportunities to profitably invest the retained funds and hence the returns end up being lower than the investor expectations and this adversely affects the owners wealth (Akhigbe & Madura 1996). This situation demands that the firm choose a high dividends policy to have the money invested by the shareholders in other high profitable alternatives in other companies. Income Stability The stability of a firm’s earnings has a great impact on the dividend policy decisions.

When the income of a firm is more steady and stable, then it is likely to choose a liberal dividend policy. This encompasses the earnings level as well. The decision for a dividend policy to be adopted is highly dependent on the stability of the firm’s earnings (Holder, et al. 1998). For instance, firms dealing with basic life commodities or public utilities are more likely to have stable income making it possible to pursue a liberal pay out ratio. On the other hand it is usually difficult for firms with unstable earnings to settle for stable dividend policy.

This choice demands extra care since it will be limited by issues of fluctuation or instability. Access to External Funding Higher access to external sources of funding implies that firms are not constrained in their choice for dividend policy. In such firms, the dividend policy choices are less dependent on the liquidity position or even the investment decision within a firm. Greater flexibility and availability of external funding sources makes it possible for companies to settle for a higher dividend policy (Brealey & Myers, 2000).

However, firms with limited capacity and flexibility for externally raising funds, internal earnings are likely to be emphasized on. The directors are led to choose a low pay out ratio whenever the firm has lesser funding opportunities and has more invest opportunities. Why a Dividend Policy Does Not Mater There are conflicting issues regarding the importance of a dividend policy. For instance, most scholars argue that dividends do not matter to a company while practitioners feel that that it does actually matter (Robert & David 2009).

The dividend policy is an important aspect of the firm’s stock value but it does not matter as there are a range of other accurate determinants of the firm value and performance. Shareholders can engage in alternative investment options to create more dividends such as in the case of stable bonds rather than relying on dividend policies which are mostly unstable. Dividends are not important as they usually are taxed more than capital aims (Bancel & Mittoo, 2002). A dividend policy may not necessarily be an accurate measure of the stock value.

Additionally, a no-dividend policy allows firms to invest their internally generated earnings into expansion plans, buying of assets which increase the firm’s shares. It is also imperative to note that dividend policies are not vital in measuring the firm value. Practical Considerations Influencing the Choice of a Firm’s Capital Structure The choice for capital structure refers to the combination of both equity and debt financing, that is, the means through which a firm finances itself through equity, debts and securities (Levy, et al. 2003).

Capital structure is basically a description of the approach by which a firm raises required capital for the purpose of establishment and expansion of business processes. It thus encompasses of a mixture of a number of debt and equity capital approaches maintained by a firm on the basis of its decisions on financing. It is usually difficult for a firm to establish an optimal capital structure (Prasad, et al. 2001). Studies on capital structure choice are inclusive of cross-country comparisons so as to enhance the understanding of the variations of aspects influencing the choices in different countries.

Moreover, cross-country comparisons play an important role in assessing the relationship between the empirical study findings and institutional differences. Firm Size Firm size plays an important role in determining a firm’s debt ratio and consequently the capital structure. Small firms limit their choice for debt-financing unlike large sized firms. There are many issues in the context of the firm that explain this phenomenon. Large firms have highly and stable cash flows as they are often more diversified than the smaller firms and this enable them to lower the risks associated with debts by avoiding debt financing.

Moreover, large firms are in a position to take advantages resulting from economies of scale by choosing to issue securities (Bancel & Mittoo, 2002). On the other hand, smaller firm, which are characterized by information asymmetries, face high costs when they choose to adopt external financing. Larger firms, being more mature, have their assets accounting for a significant portion of their value rather than growth opportunities. Unlike smaller firms, large firms benefit from more publically available information that is specific to the firm. Large firm also enjoy a more profound reputation.

These features guide the large firms in choosing to issue public debt. Tangibility Large firms are likely to have high amounts of intangible assets and therefore at a better position to reduce information asymmetries by choosing to issue debts. This implies that the firm will have higher leverage levels. Such large firms also restrict their decision to more borrowing so as to able to avoid higher monitoring costs (Frank & Goyal, 2004). Large firms, which normally have high growth rate, choose to issue debts as a strategy to increase financial image unlike in the case of outside equity financing.

Firms in industries that are growing enjoy higher flexibility in regards to the future investment choices but their choices on capital structure are limited by higher agency relationship costs. Firms with a longer debt repayment history benefit from lower borrowing costs while raising their debt finance. There is a highly positive relationship between the choice for a debt ratio and the age of firms. Tax Rate on Corporate Income The tax rate on corporate income has an important contribution on the determination of a capital structure choice.

In the event of a higher tax rate on corporate income, firms benefit from a tax shield and thus they opt for higher levels of debt finances rather than equity finances. Firms thus hold constant, the rate of tax on both personal and dividend income. In a country like China for instance, varied types of firms, even if all listed, are subject to varying rates of corporate income tax (Graham, 2003). For instance, companies which have been listed are normally subject to a 15 percent rate of tax while some are subject to a higher rate ranging up to 33 percent.

On the other hand, during the initial two years, firms which have foreign investments are exempted from tax and only subject to a 7. 5p percent in the next three years. With a higher tax rate and all other aspects remaining the same, the debt capital cost is reduced (Titman, et al. 2001). There is a positive relationship between the choice of debt ratio and the rate of corporate income tax. Timing of Equity Issues An important consideration in the determination of the capital structure by a firm revolves around the timing of equity issues.

The stock price of a firm determines the decision by managers as to when to issue stock (Baker & Wurgler, 2002). Most managers preferring to issue stock following an increase in the price of the stock and this is a vital move by the firm. This is driven by the managers’ notion that the profit per share is adversely affected by issuing of additional stock, that is, dilution of earning per share. Studies on European firms’ confirm that dilution of earning per share is held with much regard in the choice of a firm’s capital structure. Larger companies are however, not concerned with the share dilution than the small firms.

The decision for capital structure is highly influence by the effect of the timing of equity issue on the firm’s financial statements. Firms choose or adjust their capital structure to certain target structures which respond to the changes in their market value. Firms issue equity in situations when their shares’ market value is high and repurchase the equity when the share prices lower (Brealey & Myers, 2000). It is also imperative to note that firms adjust their capital structure to the targeted levels in a slow and long process.

Volatility of Earnings This refers to the risk of a business and indicates distress in financial performance within a firm. Volatility of earnings is often associated with an inverse correlation with leverage. A firm with a high earning volatility is subject to more risks since the level of earnings fall below the commitments of the debt service (Titman et al. 2001). Therefore, firms usually resolve into a funding arrangement although at a higher cost to be able to service their debts and to avoid the risk of bankruptcy.

On the other hand, if a firm opts for equity financing during the time of financial distress, it gets the opportunity to make a decision not to declare dividends. Firms with high volatility of earnings opt for less borrowing. In a situation when a firm is in a financial distress and needs external financing, a firm opts for equity other than debt. Thus, there is an inverse relationship between leverage and volatility of earnings. Liquidity Most companies prefer to fund their growth and development plans from their retained earnings rather than from external financing institutions (Booth, et al 2001).

A company’s major objective is to create liquid reserves. Therefore, a firm opts to use internal financing if it’s substantial to facilitate investments while avoiding external financing. This implies that leverage is negatively related to liquidity. Growth Opportunities Companies with low investments usually avoid investing in any positive NPV projects despite having high opportunities for growth due to existence of an outstanding debt. It is apparent that returns obtained from investing in the available opportunities will definitely be directed to debt holders and not the shareholders (Allen & Michaely, 1995).

In firms with competitive investment opportunities, the interests of both the shareholder and management (which is often focused on growth objectives) do coincide. Although with high growth opportunities, firms do not normally opt to issue debts. An inverse relationship exists between leverage and growth opportunities. Goyal, et al. (2002) argues that the companies that have high market-to-book ratios are affected by elevated costs associated with financial distress. Stocks overhaul also leads to a decision to issue stock. Profitability of a Firm

Most firms opt for internal financing rather than external financing. Firms initially opt for financing from internally generated earnings and only switch to external financing when retained earnings become insufficient. In such occasions, firms often prefer to issue debt equity rather than equity in occasions when the opportunity to apply both is available (Frank & Goyal 2004). More profitable firms choose to remain with less debt. There is a positive correlation between leverage and profitability. Firms issue debt equity to showcase their quality. Bibliography Akhigbe, A.

and J. Madura, (1996), Dividend policy and corporate performance, Journal of Business Finance & Accounting, vol. 23, no. 9 and 10, pp. 1267-1287. Allen, F & Michaely, R 1995, “Dividend policy,” in R. A. Jarrow, V, Maksimovic, & WT, Ziemba (eds. ), Handbooks in Operations Research and Management Science: Finance 9, Amsterdam: Elsevier. Baker, M & Wurgler, J 2002, “Market timing and capital structure,” Journal of Finance, vol. 57, pp. 1-32. Bancel, F, & Mittoo, U 2002, The determinants of capital structure choice: A survey of European firms, Working paper series, SSRN.

Booth, L, Aivazian, V, Demirguc-Kunt, A & Maksimovic, V 2001, “Capital structure in developing countries,” Journal of Finance, vol. 56, no. 1, pp. 87-13 Brealey, RA, & Myers, SC 2000, Principles of Corporate Finance (6th edn), New York: McGraw-Hill. DeAngelo, H, DeAngelo, L, & Skinner, DJ 2000, “Special dividends and the evolution of dividend signaling, Journal of Financial Economics,” vol. 57, no. 3, pp. 309-354. Frank, M & Goyal, V 2004, “Capital structure: which factors are reliably important? ” Working paper, Sauder School of Business, the University of British Columbia, Vancouver.

Goyal, VK, Racic, S, & Lehn, K 2002, “Growth opportunities and corporate debt policy: the case of the U. S. defense industry,” Journal of Financial Economics, vol. 64, pp. 49-66. Graham, JR 2003, “Taxes and corporate finance: A review,” Review of Financial Studies, vol. 16, 1075-1129. Hines, JR Jr 1996, “Dividends and profits: Some unsubtle foreign influences,” Journal of Finance, vol. 51, no. 2, pp. 661-689. Holder, ME, Hexter, JL, & Langreh, FW 1998, “Dividend policy determinants: An investigation of the influences of stakeholder theory,” Financial Management, vol. 27, no. 3, pp. 73-82.

Levy, A, & Korajczyk, RA 2003, “Capital structure choice: Macroeconomic conditions and financial constraints,” Journal of Financial Economics, vol. 68, pp. 75-109. Prasad, S. , Murinde, V, C, & Green, J 2001, “Company financing, capital structure, and ownership: A survey, and implications for developing economies, SUERF Studies No. 12, Vienna: SUERF Robert, P & David, SK 2009, Fundamentals of Corporate Finance. United States, John Wiley & Sons, Inc Titman, S, Hovakimian, A, & Opler, T 2001, “The debt-equity choice,” Journal of Financial and Quantitative Analysis, vol. pp. 36, 1-24.

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