Question

Explain the following factors which affect the choice of capital structure of a company?

Answer 1

Following are the factors determining the relative proportion of various types of funds, or the capital structure:

(i) Position of cash flow Size of projected cash flow must be considered before issuing debt. Cash flow must not only cover fixed cash payment obligations but there must be sufficient cash for smooth working of the business.

(ii) Return on Investment (Rol) It refers to the earning expected from the investment. If Rol of a company is high, it can opt for trading on equity to increase the earning per share. Thus, it is an important determinant of the extent of trading on equity.

(iii) Cost of capital It may be defined as the payment made by company to obtain capital. Thus, interest is the cost of debentures or loan and dividend paid by the company is the cost of equity and preference share capital. The rate of dividend on preference shares is fixed which is generally lower than that of equity shares. The cost of debentures is generally lower and tax deductible.

(iv) Risk of consideration While deciding the capital structure, risk must be analysed and considered. Total risk consists of two types of risks:

(a)Financial risk It refers to a position when a company is unable to meet its fixed financial charges namely, interest payment, preference dividend and payment obligations. It arises when a company borrows. Use of debt increases the financial risk of a business.

(b)Business risk It depends upon fixed operating costs. Higher fixed operating cost means higher business risk and vice-versa. If a firm’s operating risk is lower, its capacity to use debt is higher and vice-versa.

(v) Flexibility To maintain flexibility, a firm should not use its debt potential in full, So that it can borrow in unforeseen circumstances.