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Question : 6
Total: 6
Explain briefly any four factors that affect the choice of capital structure of a company.
Solution:
Capital structure: Capital structure means the proportion of debt and equity used for financing the operations of a business. It can be calculated as debt-equity ratio.
Factors affecting capital structure (any four):
(i) Cost of debt: When a company is able to arrange borrowed fund at lower rates of interest, it will prefer more of debt as compared to equity.
(ii) Risk consideration: Financial risk refers to that position when a company is unable to meet its financial requirement. Debt is cheaper but is more risky because interest on debt has to be paid even if company is suffering loss. So, if there is high risk in the business, then company should depend on its equity.
(iii) Return on Investment (ROI): When ROI of a company is greater than rate of interest on debt, it can use more debt to increase the profit earned by shareholders. This is called trading on equity.
(iv) Stock market condition: If the stock market are bullish, equity share can be easily issued even at higher price. However, during a bear phase a company may find it difficult to raise equity capital and hence it may opt for debt.
(v) Flotation cost: It refers to the cost of raising the funds such as broker's commission, underwriting commission, etc. Higher the flotation cost involved in raising funds from a particular source, lower is the proportion in the capital structure.
(vi) Debt-Service Coverage Ratio (DSCR): This ratio states the cash payment obligations as against the availablity of cash. It is calculated as:
Factors affecting capital structure (any four):
(i) Cost of debt: When a company is able to arrange borrowed fund at lower rates of interest, it will prefer more of debt as compared to equity.
(ii) Risk consideration: Financial risk refers to that position when a company is unable to meet its financial requirement. Debt is cheaper but is more risky because interest on debt has to be paid even if company is suffering loss. So, if there is high risk in the business, then company should depend on its equity.
(iii) Return on Investment (ROI): When ROI of a company is greater than rate of interest on debt, it can use more debt to increase the profit earned by shareholders. This is called trading on equity.
(iv) Stock market condition: If the stock market are bullish, equity share can be easily issued even at higher price. However, during a bear phase a company may find it difficult to raise equity capital and hence it may opt for debt.
(v) Flotation cost: It refers to the cost of raising the funds such as broker's commission, underwriting commission, etc. Higher the flotation cost involved in raising funds from a particular source, lower is the proportion in the capital structure.
(vi) Debt-Service Coverage Ratio (DSCR): This ratio states the cash payment obligations as against the availablity of cash. It is calculated as:
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