Factors affecting Capital Structure PPT.pptx

factors influencing capital structure

1. Factors Affecting capital Structure Business Studies Class XII

2. i ) Cash flow position: Cash flow must be enough to cover normal business operation & investment on fixed assets . Cash flow must cover payment obligations such as normal business operations, investment in fixed assets & payment of interest.

3. ii) Interest Coverage Ratio (ICR): It refers to number of times earnings before interest & tax (EBIT) of a company covers interest obligation . If it is high, the risk of company failing to meet its interest obligation is low.  

4. iii) Debt Service Coverage Ratio (DSCR): The cash profit generated by the operations is compared to total cash required to service the debt (cash required to pay debt). A higher debt service coverage ratio indicates better ability to make cash commitments & company potentiality to increase debt component in capital structure.  

5. v) Cost of debt: If the return on investment of the company is higher, it can choose trading on equity to increase its earnings per share (EPS). iv) Return on Investment (ROI): A firm’s ability to borrow at lower rate increases its capacity to employ higher debt . Thus, more debt can be raised at lower rate.

6. vii) Cost of equity: Since, the interest is deductible expense, cost of debt is affected by tax rate . A higher tax rate makes debt cheaper. The interest paid on debt is deductible from tax. vi) Tax rate: Stockholder’s expect a rate of return on their investment. When a company increased debts, the financial risk faced by equity shareholders increases . For this reason company may noy employ debt more than certain point.

7. ix) Risk consideration: Process of raising sources also includes some cost. Public issue of shares & debentures requires some expenditure . Loan from financial institution may not cost much. This also affects debt & equity. viii) Floatation cost: The total risk depends on both business risk & financial risk . If the firm’s business risk is lower, its capacity to use the debt is higher & vice versa.

8. xi) Control: To maintain flexibility, a firm should not use all of its ability to borrow debt . It must maintain some borrowing power to take care of unforeseen circumstances. x) Flexibility: Debt normally does not cause reduction of management’s control on the company . A public issue of share may reduce management’s control on company.

9. xii) Regulatory framework: Every company operates within a regulatory framework provided by law . Ease with these norms might affect choice of source of funds. Public issue of shares & debentures has to be made under SEBI guidelines . Raising funds from banks & other financial institutions require fulfillment of other norms (requirements).

10. xiv) Capital structure of other companies: If stock markets are bullish, equity shares can be easily sold even at higher price . However in bearish phase, a company can find raising equity capital is more difficult. xiii) Stock market condition: A useful guideline in capital structure is the debt – equity ratio of other companies in the same industry. These are usually some industry norms which may help.