From the course: Finance Foundations

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Factors influencing optimal capital structure

Factors influencing optimal capital structure

From the course: Finance Foundations

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Factors influencing optimal capital structure

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So what is the optimal capital structure? Well, it depends on the specific business circumstances. For example, let's do a little thought experiment. If income tax rates are high, should a company have more borrowing in its capital structure or less? Well, let's think this through. If tax rates are high, that means I get a bigger tax deduction for interest. If I get a bigger tax deduction for interest, then loans are cheap and I want to borrow relatively more. So in a situation where income tax rates are high, companies would tend to have more borrowing in their capital structure. What about the quality of the collateral associated with loans? If a company has very good collateral, then it's more likely to borrow more. What about the stability of the cash flows of the business? If you have a company that has very stable, predictable cash flows, you're able to borrow more. Stable cash flows give comfort to the lender, so you can borrow more. With volatile cash flows, banks are probably…

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