Capital Structure Decisions: Evaluating Risk and Uncertainty

Chapter Two

Time Dimensions of Capital Structure Decisions

CAPITAL STRUCTURE DECISIONS ARE long-term decisions involving the acquisition, retention, and redemption of funds at various time periods. We draw from economics the definition of long run, where all sources contributing to capital can be changed, and short run, where at least one source of capital is fixed. The capital needs of a firm for strategic dimensions have a long run period, but for operational and tactical decisions, firms have a short run period to devise the structure. Short-run decisions are enveloped by the long-term perspectives of a firm, of which the most important dimensions are flexibility and credit risk. During the initiation stage of business, restructuring, or liquidation, all sources of capital can be changed or adapted but not otherwise. The risk and uncertainty of the obligations arising out of capital sources increase as we go further in time. For the same reason, equity funding is considered more risky than debt.

Firms need to keep three things in mind before raising funds. First, the amount of cash flow that is sought by the action (both inflow and outflow); second, the time horizon for which the funds are to be raised and retained; third, the financial (such as interest charges, government taxes, and others) and nonfinancial obligations (such as risk perception, transition probabilities of credit defaults, and others) associated with the funds. Fund acquisition and redemption periods involve ...