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What is meant by Target Capital Structure?
The ultimate capital structure formed with debt, equity, and preferred debt that a company strives to obtain is known as the target capital structure of a company. The target capital structure of a company is decided depending upon some factors that are related to the financial condition of the company.
Usually, companies define their target capital structure by optimizing the values of debt and equity and they make sure that the risk associated with the target capital structure is minimum. The company uses its target capital structure while it raises new capital from the market.
Factors that Affect the Target Capital Structure of a Company
The following factors determine the target capital structure of a company −
- Cost of Funds
- Business Risk
- Availability of Funds
- Types of Funds
Let's discuss each of these factors in detail.
Cost of Funds
Cost of funds is the most important factors that companies must address while building a target capital structure of a company. The cost of funds is the interest rates investors affix to debt that the company borrows from the lenders.
A company must show returns more than the cost of funds to keep the investments intact. If the lenders find that a company is unable to get enough ROI to offer profitability they will probably take their investment elsewhere.
Business Risk
Risk is another important factor that companies must include while forming its target capital structure. Usually, shareholders invest in a company viewing the company's risk propositions. If shareholders think that the company won't be able to provide the required returns, they will not invest further in the company. This will make the company less competitive in the market and the company will find it more troublesome to raise more money in case they need it. This will impact the target structure in a negative manner.
Availability of Funds
The funds sought by companies from the lenders and borrowers are often full of friction and growing funds are less likely to be available in the market. As the funds increase, the ROI must also increase to meet the needs of the lenders which means that the companies that raise funds from the lenders will find it less likely when their needs go up. Non-availability of funds with growing needs is an implied factor even when it is not mentioned directly in case of funding.
Types of Funds
For different types of debts, there are different interest rates applicable to the funds. It is usually a wiser option to take the help of shareholder funds than loans when the amount is high. This is so because shareholder's funds have a low interest rate attached to it. The case is similar with debts and equity because equity is costlier than debt.
Conclusion
Companies that want to make a good capital structure must have these factors under consideration. While it seems easy to get a good job done while structuring the capital to be raised, in practice, it is difficult to do so. Therefore, companies must be careful and ready to do the homework before actually raising the funds.
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