Developing a capital structure
Capital structure theory emphasize on the balance between debt and equity. Due to tax debt is considered a cheaper method of capitalization than equity however if a company leverages excessively it increases risks of financial distress.
Companies use a more practical approach in designing a capital mix by considering at the cost of capital, alignment of capital structure with strategy, flexibility to respond to rapidly changing market conditions and focus on liquidity to minimize reliance on external financing.
Leading companies manage capital structure effectively to take advantage of opportunities, manage risk and meet the changing needs of the business. The following are some of the best practices used by companies in designing capital structure:
1. Select the instruments that effectively meets company’ s funding requirements
There is no one single source or a combination of sources of capital is appropriate for a company. Leading companies evaluate available funding options, pros and cons of debt and equity and cost of capital in order to understand the financial, regulatory and operational risks they are likely to face.
Each company will take the options that best fit it with the confidence that it has flexibility to handle a drastic change in the business.
2. Align capital structure with company strategy
Best practice companies develop a capital mix that supports the company strategy leaving room for flexibility to be able to respond to changing business environment.
By determining an appropriate credit risk threshold and putting in place a disciplined private equity management tactics, effective companies create a capital structure that supports organizational objectives and operational excellence.
3. Establish the company’s cost of capital
Leading companies keep awareness of their cost of capital to accurately determine threshold of capital investment. The most popular method to compute cost of capital is getting a company’s weighted average cost of capital (WACC).
WACC formula is straight forward but can be complicated by fluctuating input that determines its outcome. Leading companies regularly keep measuring its cost of capital to keep a close tab where its losing or gaining value.
The companies that use various different methods of computing WACC get a more comprehensive understanding of their position and enable them to make better strategic decisions to deal with the industry and its competitors.
4. Make effort to reduce cost of capital on an ongoing basis
Leading companies strive to make efforts to reduce cost of capital. While ways of reducing cost of capital may not be specific their cumulative effects may help a company reduce cost of capital through strategy as opposed to just cutting capital cost.
Best practice companies exercise financial transparency to attract investors who offer their capital at lower cost than competitors.
They keep good relationship with banks to enjoy favorable lending rates which in turn has a positive impact on the profitability.
5. Manage flexible capital actively
Best practice companies are proactive in balancing debt to equity ratio to be able to respond to internal and external factors that affect cost of capital. Flexible financial policies that affect dividends where lower amounts can be paid as dividend and the rest retained to grow the business are useful to many companies.
6. Keep exploring new finance sources continuously
Best practice companies move from reliance on traditional sources of capital like commercial banks, public debt, equity markets or institutional investors to avoid being victims of the changes in the market by continuously searching for alternative non traditional sources of capital on a continuous basis.
They partner with other business, use assets as collateral and creating corporate structures to insulate the parent company from excessive risks.
Capital structure is about balancing debt and equity, however too much debt may increase unseen risks.
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