What should be taken into account in designing capital structure?

Because there is no optimal capital structure, the choice between debt and equity will depend on a number of considerations:

a)       Macroeconomic conditions. High real (inflation-adjusted) interest rates and low activity     growth will prompt companies to de-leverage. Inversely, rapid growth and/or low real interest rates will favor borrowing.

b)       The desire to retain a degree of financial flexibility so that any investment opportunities that arise can be quickly seized. To this end, equity financing is preferred because it creates additional borrowing capacity and does not compromise future choices. Inversely, if current borrowing capacity is used up, the only source of financing left is equity; its availability depends on share prices holding up, which is never assured.

c)       The maturity of the industry and the capital structure of competitors. A start-up will get no financing but equity because of its high specific risk, whereas an established company with sizeable free cash flows but little prospect of growth will be able to finance itself largely by borrowing. Companies in the same business sector often mimic each other.

d)       Shareholder preferences. Some will favor borrowing so as not to be diluted by a capital increase in which they cannot afford to participate. Others will favor equity so as not to increase their risk. It is all a question of risk aversion.

e)       Financing opportunities. These are by definition unpredictable, and it is hard to construct a rigorous financing policy around them. When they occur, they make it possible to raise funds at less than the normal cost – but at the expense of the investors who have deluded themselves.