Question

Explain any four factors that affect the choice of capital structure of a company. 

Answer 1

Capital Structure refers to the combination of different financial sources used by a company for raising funds. The following factors affect the choice of capital structure in a company:

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 principle amount on the debt.
So,
Strong Cash flow ⇒ 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. Algebraically,

DSCR=Profit after Tax+Interest+Depreciation+Non−Cash ExpensePreference Dividend+Interest+Repayment of ObligationDSCR=Profit after Tax+Interest+Depreciation+Non-Cash ExpensePreference Dividend+Interest+Repayment of Obligation

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 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 rate of return increases. This relationship suggests that a company cannot increase the component of debt in its capital structure beyond a certain point.
So,
Higher financial risk ⇒ Greater expectation of rate of return on equity ⇒High cost of equity ⇒ Difficult to opt for equity
Lower financial risk ⇒ Lower expectation of rate of return on equity ⇒Low cost of equity ⇒ Easy to opt for equity
d. Condition of 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 equity share.
So,
Good stock market condition ⇒ Easy to opt for equity
Poor stock market condition ⇒ Difficult to opt for equity