Question

Answer the following question.
'Determining the relative proportion of various types of funds depends upon various factors.' Explain any six such factors.

Answer 1

The relative proportion of various types of funds i.e. the capital structure depends upon various factors.

The factors are discussed below:
1. 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

2. 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

3. 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

4.  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 debt and less of equity in the capital structure.

5. Regulatory guidelines: Every company has to operate as per the regulatory guidelines framed by the law which determines procedures to be followed while raising the funds from different sources. The more liberal the guidelines, the easier it is to obtain the funds from a particular source, and hence the greater is the proportion of that fund in the capital structure. 

6. Tax rate: As interest paid on debt is a tax-deductible expense, this suggests that the higher the tax rate, the lower is the cost of debt, and therefore, the higher is the probability for the firm to increase the proportion of debt in its capital structure.
High tax rate ⇒ Cheaper debt ⇒ Higher proportion of debt in capital structure
Low tax rate ⇒ Costly debt ⇒ Lower proportion of debt in the capital structure.