Question

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

Answer 1

Following are the factors that affect the capital structure of a company :

Cost of Equity: Another factor that helps in deciding capital structure is the cost of equity. Owners or equity shareholders expect a return on their investment i.e., earning per share. As far as debt is increasing earning per share (EPS), then we can include it in capital structure but when EPS starts decreasing with the inclusion of debt then we must depend upon equity share capital only.

Floatation Costs: Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost of advertisement, underwriting statutory- fees, etc. It is a major consideration for small companies but even large companies cannot ignore this factor because along with cost there are many legal formalities to be completed before entering into the capital market. The issue of shares, debentures requires more formalities as well as more floatation costs. Whereas there is less cost involved in raising capital by loans or advances.

Risk Consideration: Financial risk refers to a position when a company is unable to meet its fixed financial charges such as interest, preference dividend, payment to creditors, etc. Apart from financial risk business has some operating risk also. It depends upon operating cost, higher operating cost means higher business risk. The total risk depends upon both financial as well as a business risk. If the firm’s business risk is low then it can raise more capital by issue of debt securities whereas at the time of high business risk it should depend upon equity.

Flexibility: Excess of debt may restrict the firm’s capacity to borrow further. To maintain flexibility it must maintain some borrowing power to take care of unforeseen circumstances.