Question

Answer the following question.
'Determining the overall cost of capital and the financial risk of the enterprise depends upon various factors.' Explain any six such factors.

Answer 1

The factors affecting the capital structure are:

a. Position of cash flow: The cash flows (the inflows and outflows of cash) of a company should be such that it is able to cover its various payment obligations (such as interest payments and normal expenses of the business) and is left with some surplus as well. In this regard, the company opts for debt capital only in a position of strong cash flow. This is because, in case of debt, cash is required to pay the interest as well as the principal amount on the debt.
Strong Cashflow ⇒ More debt
Low Cash flow ⇒ More Equity

b. Debt-Service Coverage Ratio (DSCR): This ratio shows the cash payment obligations of the company as against the availability of cash. That is, it reflects the cash flow position of the company.
Higher DSCR ⇒ Higher cash flow ⇒ Company can increase the proportion of debt in its capital structure.

c. Equity cost: The rate of return expected by the shareholders is directly related to the risk associated with their investment. As the financial risk faced by the company increases, the shareholders’ expectation of the rate of return increases, and vice versa. Now, as the company increases the component of debt, the financial risk faced by it also increases. Therefore, the shareholders’ expectation of the rate of return increases. This relationship suggests that a company cannot increase the component of debt in its capital structure beyond a certain point.
Higher financial risk ⇒ Greater expectation of the rate of return on equity ⇒High cost of equity ⇒Difficult to opt for equity
Lower financial risk ⇒ Lower expectation of the rate of return on equity⇒Low cost of equity ⇒Easy to opt for equity

d. Condition of the stock market: In situations of a good stock market, a company can easily opt for equity share capital. As against this, in case of poor stock conditions, it becomes difficult for the company to opt for an equity share.
Good stock market condition ⇒Easy to opt for equity
Poor stock market condition ⇒Difficult to opt for equity

e. Interest Coverage Ratio: It refers to the number of times the ‘earnings before interest and tax’ (EBIT) is able to cover the interest obligations of the company. The higher this ratio, the higher is the number of times that the company would be able to meet its interest obligations and the lesser is the financial risk.
Thus, the company can opt for a higher proportion of debt in the capital structure and vice versa.
High-interest coverage ratio⇒ Low financial risk ⇒ Higher proportion of debt
Low interest coverage ratio⇒ High financial risk ⇒ Lower proportion of debt

f. Floatation cost: It refers to the cost of raising funds such as the broker’s commission and underwriting commission.
The higher the floatation cost involved in raising funds from a particular source, the lower is its proportion in the capital structure. For instance, if the public issue of shares involves higher floatation cost than debt, then the company would opt for more of debt and less of equity in the capital structure.