- Background of the study
The most important decision all corporate managers should take into consideration is the way in which the long-term capital requirements of their companies should be financial. Capital structure is the permanent financing of a firm represented primarily by equity and long-term liability without including all short-term credits. Many factors have to surface in order to determine the capital structure of a business organization. These factors are what the financial managers consider first in order to determine appropriate capital structure suitable to his firm. Some of the factors are: cost of capital, floation costs, size of the company, government policies and market condition. The combination of debt and equity has some implication. The first is that debt-equity ratio, which is regarded as an indicators of risk. According to Samuel etal (1992:44) high fixed interest commitment which must be paid by the business organization irrespective of whether profits are made or not. Debt capacity which is the ability of a firm to service its debt payment of interest and principal is usually measured. One of the ways of measuring debt capacity is by raising the ratio of net cash inflow to interest charges.
Pandey (1998-656) has it that the ratio indicates the number of times the interest obligation is covered by the next cash inflows generated by the company. The greater the coverage the lower the risk arising from the debt in the capital structure. Conversely, the lower the coverage the higher is the risk arising from the debt in capital structure. And failure of a company to pay its interests obligation can lead to bankruptcy. Furthermore, left for the business owners, they will employ more of debt in their capital structure as to increase profit. All things being equal will accrue to them and they only have to pay interest to provide of debt capital. Thus less amount of tax is paid by the company with debt capital.
In determining whether to employ more of debt and less of equity or more of equally and less of debt in its capital structure, the financial managers of the firms concerned should take into account, the profit objectives of that business. They should consider how the capital structure will affect the profitability of their business organization. The profitability of any business organization will determine whether it will remain in business or not especially in the long run. Profitability is normally measured using return on capital employed return on equity, earning per share, return on assets, net profit margin and gross profit margin.