Question

Explain briefly any four factors which affect the choice of capital structure of a company.

Answer 1

Factors which affects the choice of capital structure- ( any four)

(1) Cash Flow Position:

While making a choice of the capital structure the future cash flow position should be kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash is needed in order to make payment of interest and refund of capital.

(2) Interest Coverage Ratio-ICR:

With the help of this ratio an effort is made to find out how many times the EBIT is available to the payment of interest. The capacity of the company to use debt capital will be in direct proportion to this ratio.

(3) Debt Service Coverage Ratio-DSCR:

This ratio removes the weakness of ICR. This shows the cash flow position of the company.

This ratio tells us about the cash payments to be made (e.g., preference dividend, interest and debt capital repayment) and the amount of cash available. Better ratio means the better capacity of the company for debt payment. Consequently, more debt can be utilised in the capital structure.

(4) Return on Investment-ROI:

The greater return on investment of a company increases its capacity to utilise more debt capital.

(5) Cost of Debt:

The capacity of a company to take debt depends on the cost of debt. In case the rate of interest on the debt capital is less, more debt capital can be utilised and vice versa.

(6) Tax Rate:

The rate of tax affects the cost of debt. If the rate of tax is high, the cost of debt decreases. The reason is the deduction of interest on the debt capital from the profits considering it a part of expenses and a saving in taxes.

For example, suppose a company takes a loan of 0ppp 100 and the rate of interest on this debt is 10% and the rate of tax is 30%. By deducting 10/- from the EBIT a saving of in tax will take place (If 10 on account of interest are not deducted, a tax of @ 30% shall have to be paid).

(7) Cost of Equity Capital:

Cost of equity capital (it means the expectations of the equity shareholders from the company) is affected by the use of debt capital. If the debt capital is utilised more, it will increase the cost of the equity capital. The simple reason for this is that the greater use of debt capital increases the risk of the equity shareholders.

Therefore, the use of the debt capital can be made only to a limited level. If even after this level the debt capital is used further, the cost of equity capital starts increasing rapidly. It adversely affects the market value of the shares. This is not a good situation. Efforts should be made to avoid it.

(8) Floatation Costs:

Floatation costs are those expenses which are incurred while issuing securities (e.g., equity shares, preference shares, debentures, etc.). These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of issuing debt capital is less than the share capital. This attracts the company towards debt capital.

(9) Risk Consideration: There are two types of risks in business:

(i) Operating Risk or Business Risk:

This refers to the risk of inability to discharge permanent operating costs (e.g., rent of the building, payment of salary, insurance installment, etc),

(ii) Financial Risk:

This refers to the risk of inability to pay fixed financial payments (e.g., payment of interest, preference dividend, return of the debt capital, etc.) as promised by the company.

The total risk of business depends on both these types of risks. If the operating risk in business is less, the financial risk can be faced which means that more debt capital can be utilised. On the contrary, if the operating risk is high, the financial risk likely occurring after the greater use of debt capital should be avoided.

(10) Flexibility:

According to this principle, capital structure should be fairly flexible. Flexibility means that, if need be, amount of capital in the business could be increased or decreased easily. Reducing the amount of capital in business is possible only in case of debt capital or preference share capital.

If at any given time company has more capital than as necessary then both the above-mentioned capitals can be repaid. On the other hand, repayment of equity share capital is not possible by the company during its lifetime. Thus, from the viewpoint of flexibility to issue debt capital and preference share capital is the best.